The Bond Issue Controversy: An Analysis

Image courtesy Ada Derana

By Sam Samarasinghe and Dushyantha Mendis

The issue of government bonds on February 27 has raised a huge controversy, involving questions as to the competence of the Government of Sri Lanka (GOSL) and the Central Bank of Sri Lanka (CBSL), and also allegations of insider dealing. The government has been slow to respond to the public outrage the controversy has evoked. This article tries to explain the intricacies of the issues involved in this controversy. We believe that a more informed public will be better able to hold accountable those who are responsible for the events that occurred and thereby contribute to the cause of Yaha Paalanaya.

Allegations

The allegations of insider dealing involve a private company named Perpetual Treasuries. One of the major shareholders of this company is Arjun Aloysius, the son-in-law of the recently appointed Central Bank Governor Arjuna Mahendran.  This family connection has cast a shadow over the Governor himself.

The facts concerning the February 27 Treasury Bond controversy as understood by us are from, among other sources, press releases issued by CBSL, media reports and a statement issued by the Ministry of Policy Planning and Economic Affairs on March 06. Almost all the data used in this article come from CBSL.

The issues arising from the controversy – or criticisms that can and are being made – of the auction of February 27 and its outcomes can be briefly stated as follows:

1) The amount of debt accepted by CBSL at the auction was vastly in excess of the amount that had earlier been communicated to the primary dealers who would be bid at the auction.  Whereas the original announcement was for Rs 1bn, the amount accepted at the auction was Rs 10bn.

2) Whether there was any need to issue 30-year bonds as opposed to those of shorter tenor.

3) The interest rate resulting from the auction was much higher than the rate indicated by CBSL to the primary dealers before the auction and the country has quite arbitrarily been landed with sustaining a very large debt at an unnecessarily high rate of interest.

4) That the pattern of activity of Perpetual Treasuries before, at, and after the auction gives rise to reasonable suspicion of that company having acquired some inside, privileged knowledge.

We shall take up each of these issues in turn, but before we delve into the present controversy it is useful to briefly provide the context and background to this event.

Budgetary Financing

In the past 65 years from 1950 the GOSL has been responsible for about 20% to 25% of total spending in the country. During that period, in all but two years (1954 & 1955) GOSL has had a budget deficit. In 2014 it was estimated at Rs 552b (27.8% of total spending) and for 2015 at Rs. 499b (23.5%). In the last two decades GOSL investment spending has been financed mostly with borrowed money. In 2015 the Sirisena government expects to spend Rs 520b on development. It hopes to borrow Rs 251b from foreign sources and Rs 248b from local sources. The latter will split as follows: Rs 70b from banks, Rs 40b from foreign investors who would buy Treasury Bills and Treasury Bonds and Rs 138b from EPF, ETF and other local sources.

Central Bank

In common with any Central Bank (CB) in the world, the main task of the CBSL is to manage the nation’s money and credit system. It is the sole authority to issue currency. It is also the agency that sets interest rates that banks usually follow when setting their own rates. It is the Central Bank’s responsibility to keep inflation under control. The Central Bank is the chief regulator of commercial banks and also acts as the lender of last resort to them.

In Sri Lanka CBSL also acts as the agent of the Treasury to raise loan funds, a task that some though not all CBs in other countries also perform.

Treasury Bonds

GOSL has borrowed funds locally for decades. Until the mid 1990s the government used three month, six month, and one year Treasury Bills, longer term rupee securities and loans for local borrowing. Commercial Banks in Sri Lanka, Savings Institutions, Insurance and Finance Companies and EPF were the major sources of funds.

In March 1997 a very significant change was made in the way that government borrowed locally. GOSL decided with the advise of the IMF to introduce Treasury Bonds (as opposed to Treasury bills, which are for periods less than an year) that could range from 2 years to as long as 30 years or even longer. The “new” Treasury Bonds were the same as the old “Securities.” The new name simply aped a term used in the USA. The real difference was that under the new system Treasury Bonds were sold in the open market in an auction through a competitive bidding system. The economic rationale was to make resource (fund) allocation more market-oriented. Only registered financial institutions called “Primary Dealers” (PD) were allowed to place bids. As of today there are sixteen PDs of which nine are affiliated to banks and seven are private non-bank companies. Among these latter is Perpetual Treasuries, the company at the center of the present controversy.

With that as background, we can enter the discussion of the issues set out before. More background information necessary to understand the issues involved would be provided when discussing the specific issues.

1) The amount accepted at the auction.

While a government bond auction for Rs. 1.0b had been scheduled for Friday February 27, at a meeting on Thursday February 26, the Minister of Finance, the Minister of Highways, Investment Promotion and Higher Education, the Secretary to the Treasury and the Governor of the Central Bank had agreed on the government’s urgent need for Rs 15b. Though not officially acknowledged, it has been revealed later that the Chairman of the UNP and leading businessman Malik Samarwickrema had also attended this meeting.

For the bond auction on February 27, most dealers had made preparations to provide bids for the already announced Rs. 1.0b. But at the auction, bids were accepted for amounts up to Rs. 10.0b.  While accepting amounts greater than the bid has happened before, as shown in Table 1 below, the February 27 issue was of a scale (ten times the original offer) that was totally unprecedented.

Table 1: 30-Year Treasury bond Issues in Sri Lanka, May 2013-February 2015

Source: Central Bank of Sri Lanka, www.cbsl.gov.lk/htm/english/_cei/ei/e_1.asp

Table 1 shows some details of the six sets of 30-year Treasury bonds that have been issued between 30 May, 2013 and 27 February, 2015. The following features are noteworthy.

1. The February 27 Bond offer was only Rs 1.0b, the lowest offer of the six.
2. The February 27 bond also deviates from the rest in terms of the bid to offer ratio. In the earlier five sets of bonds, the bids were around two to four times the offer. The bids on February 27 total 20 times the original offer.
3. The amount accepted, Rs 10b, was on par with that of the July 2013 bond. In the latter case the Bank accepted an amount equal to what was offered. In three of the previous five issues, what was offered was what was accepted and in the other two the acceptance exceeded the offer by 50% and 10% respectively. In the February 2015 issue the Bank accepted ten times the amount originally offered.

It would be readily apparent that accepting higher amounts than earlier notified, breaches the understanding that dealers work on.  It also enables those who may have had inside information of the increased amount to be offered, to profit at the cost of those who lack such information.  Apparently, dealers had expressed their dissatisfaction with this practice even under the previous administration, though then, as already noted, the excess amounts accepted were much smaller than that accepted at the auction of February 27.

The Sunday Times reported on March 8 that ‘The money markets were in an uproar on Friday, February 27 when the CBSL announced that it was accepting bids worth Rs. 10.0b at 9.50%-12.50% whereas clients and most primary dealers had made bids between 9.50% and 10.50%, not in the 11%-12% range. Only a few bids, including those by Perpetual Treasuries were made in the 12% range.”

The questions that arise are:

10. a) If GOSL found on February 26 that it needed to raise Rs 10.0b in loans at the next (February 27) Treasury bond issue, why was that information not communicated to all the primary dealers prior to the auction?
11. b) The government presented a revised budget for 2015 at the end of January. Why were the revenue and expenditure streams not accurately estimated in that exercise so that borrowing could be streamlined to hold Treasury bond rates at the lowest possible level?
12. c) In it’s statement of March 6, the Ministry of Policy Planning and Economic Affairs observes that “The Government’s immediate needs for cash to make payments for the bills in hand and to complete incomplete projects were to be met through the Treasury bond issues in March 2015.” If that was the case why raise $10b in one rushed issue on February 27 with interest rates as high as 12.5% when the issue could have been spread out at least over the next few weeks or even a month?
13. d) Senior members of the government would have been aware that the Government of India was preparing to shortly offer a currency swap worth $1.5b (Rs 198b) that would ease financial pressure and ease interest rates. This also calls into question the need for issuing a 30-year bond at high interest.

2) The need to issue thirty-year bonds

Why issue thirty-year bonds at all which commit taxpayers to pay high interest for such a long period of time? For borrowers the only argument for very long-term bonds is if they lock in low interest rates for a long period. That was not the case in this instance.

If the government wanted funds immediately to settle payments, a one-year Treasury Bill could have been issued for say 8% and rolled over periodically until government finances stabilized. It is important to note that the taxpayer has to pay Rs 100 million in interest for each additional one percentage point in interest for a 30-year Rs 10.0b bond issue.  At a weighted average interest rate (net of taxes) of 11.73%, the lenders will get back Rs 10.0b in interest earnings in about 8.5 years. Thus Sri Lanka will be paying the amount of the original amount borrowed at least three times over by way of interest payments only.

3) The Interest Rate

Here what is of concern is not only the interest rate actually resulting from the auction, but a policy change by CBSL on February 27, effective March 2.

The Central Bank has some tools at its disposal to nudge market interest rates in the direction that it wants. One of the key tools is the interest rate that it charges when banks want to borrow money from it (Table 2, Column 3). It stood at 9.0% in mid 2013. It was cut to 8.5% in October of that year and further to 8.0% in January of 2014 at which level it still remains. This is indicative of the fact that the CBSL was happy to see market interest rates being reduced.

In September 2014 CBSL took a decision that signaled to the banks that it wanted market interest rates to go down further. The Bank has a facility called the Standard Deposit Facility (SDF) that allows commercial banks to place their excess funds with the CBSL. (“Excess funds” are money that banks are temporarily unable to use for ordinary loans because they have no creditworthy borrowers. They place such funds with the CBSL until such time that demand for loans increase). CBSL then paid 6.5% for such deposits. Starting September 2014 the Bank decided to pay 6.5% only for the first three deposits made by any given bank in a calendar month and pay the lower rate of 5.0% for any additional deposits that a bank would make.  This reduction was meant to further drive down market interest rates.

On Tuesday February 24, the CBSL issued its Monetary Policy Review for the month, indicating that Central Bank interest rates would remain unchanged.  The Review states that “…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. Access to the Standing Deposit Facility (SDF) will remain rationalised.”

What the last sentence meant in simple English was that the decision the Bank took in September 2014 to pay a lower interest of 5.00% to banks under SDF would remain in force. This was a signal to the market that the Bank was not keen to see an increase in interest rates.

On Friday February 27, CBSL apparently had revealed that with effect from Monday March 2 it would scrap the 5% SDF rate, thus consistently paying commercial banks 6.5% on their deposits with the Central Bank. This is contrary to the decision, already quoted above, that the CBSL announced on February 24 (just three days before), that it would keep the CBSL policy rates unchanged.  In a press release dated Tuesday March 03 however, CBSL announced that the 5% SDF window has been abolished with effect from March 02, something it had already indicated on February 27.

This procedure, on the face of it appears to be awkward if not downright unprofessional. The abolition of the 5% window would increase the inter-bank borrowing rates, thereby generally increasing interest rates, and reducing the market price of bonds because the price of bonds is always inversely related to the rate of interest.

For example, consider a government bond with a nominal face value of Rs 100. Suppose it has a lifetime of ten years and a coupon rate of interest of 5%. Whoever who owns it would be entitled to receive 5% (Rs 5) from the government on the completion of each year during the lifetime of the bond. (The Sri Lanka government in fact pays bond holders the interest in two six monthly installments.) If the government issues a new ten-year bond with a coupon rate of 10%, the market value of the previously issued bond will necessarily fall to Rs 50 because it is at that price its annual interest earning (called the yield) of Rs 5 will provide a 10% rate of return to whoever buys it. That means those who held the old bonds will see the market value of their bonds halved if they try to sell them before maturity.

It is also not necessary for new bond issues to take place for the price of existing bonds to be affected. For example, if foreign funds flow into Sri Lanka making more funds available to banks, market interest rates will fall.

Having on February 24 made a commitment to keeping the then structure of interest rates unchanged, why did the Central Bank on February 27– just three days after it’s Monetary Policy Review – announce changes calculated to increase interest rates? This question is important because if the announcement was made before the auction, it creates expectations that interest rates could increase. If the announcement was made after the auction it appears to be an attempt to justify the acceptance of bids made at high interest rates.

There are conflicting reports about the indicative rate for the Rs 1.0b bond offer that the Central Bank had given to the primary dealers but it appears to have been in the range of 9.5% to 10.5%.  Some reports put it closer to former figure.

The issue of the 30-year bond worth Rs 10.0b on February 27 must be understood in the light of falling and comparatively low interest rates in the market.

Table 2: Sri Lanka: Interest Rates – 2013-2015

Source: Central Bank of Sri Lanka: http://www.cbsl.gov.lk/htm/english/_cei/ei/e_1.asp

* Officially this rate is called the Standard Lending Facility Rate (SLFR). The rate was reduced from 9.0% to 8.5% in October 2013, and to 8% in January 2014.

**This rate is officially called the Sri Lanka Inter-Bank Offer Rate (SLIBOR) – 12 Month Rate

*** Average Weighted Prime Lending Rate – Six Months

Table 2 shows a few key interest rates that have prevailed in Sri Lanka between May 2013 and February 2015. During this 22 month period six 30-year bonds were issued in the months that are noted in column (1). The interest rates in the Table are among those that matter most in bank lending. They also heavily influence the rates that the government has to pay for its borrowing from the market.

Column (2) shows the annual rate of inflation as measured by the consumer price index. Columns (3), (4) and (5) show three key interest rates in Sri Lanka. The rate in column (3) is the rate that the Central Bank charges commercial banks for money that it lends to commercial banks. The rate in column (4) is the rate that commercial banks charge from other banks when they lend to each other. Column (5) shows the rate (called the “Prime Rate”) that commercial banks charge their best and most trustworthy customers.

This Table reveals a couple of very important facts. First, it shows that between June 2013 and February 2015 the rate of inflation has come down. Between mid 2013 and mid 2014 it has roughly halved from 7.3% to 3.2%. It has drastically dropped to 0.6% by February 2015. The latter figure may have captured at least some of the price reduction made in the January 2015 budget of the new government.

The interest rate is the price of loans. It is logical that when prices of other goods and services drop the price of loans also to drop. In a market economy a drop in inflation is usually associated with a drop in interest rates. This association held in respect of market interest rates that prevailed in Sri Lanka after mid 2013. For example, the commercial bank prime rate more than halved from 13.89% in May 2013 to 6.5% in February 2015 (column 5 of Table 2). The interest rate banks paid to other banks for borrowed funds also dropped from 12.97% to 7.24% (column 4 of Table 2).

Column (7) of Table 1 shows the interest rates paid on the different bonds. It is the annual weighted average yield that the bondholders get. The government taxes interest income earned from bonds. The lender gets paid the interest after the tax is deducted. Hence the rates are shown as the yield net of taxes. It is a “weighted average” because primary dealers bid at different interest rates. The Bank accepts the lowest bids up to the total amount that it wants as a loan. Thus the rate shown in Table 1 is an average.

 A review of the bids that were accepted at the auction of February 27 shows the following:

1. The Central Bank reports that the weighted average after tax yield was 11.73%. (It should be noted that the Ministry of Policy Planning and Economic Affairs, in its statement of March 6, reported that the average interest rate was only 11.5%.) The spread in the 26 bids that the Bank accepted ranged from 9.35% for a Bank of Ceylon bid of Rs 8.0m to 12.5% for a Bank of Ceylon bid of Rs 3.0b.
2. CBSL could have raised the Rs 1.0b that it originally wanted paying a rate of less than 10.5%.
3. If CBSL had raised only Rs 3.26b. (thrice the initial offer of Rs 1.0b), 11.25% would have been the highest interest rate that the Government would have had to pay and the weighted average rate would have been only 10.82%.
4. CBSL could have raised Rs 5.6b at a rate of about 11.14%.
5. On February 27 the Central Bank accepted four bids – Rs 250m (11.5%), Rs 250 (11.75%), Rs 500m (11.99%), and Rs 1,000m (12.25%) – totaling Rs 2.0b that Perpetual Treasuries made. In addition, media reports say that the Bank of Ceylon bid for Rs 3b at 12.5% was also made on behalf of this company. These bids carry some of the highest rates in the Rs 10.0b that the CB accepted.

73.5% of the bids accepted with an interest rate of 11.5% or more were taken up by Perpetual Treasuries and Bank of Ceylon.

None of the bids of Perpetual Treasuries would have been accepted in scenarios 2 and 3 above.

Critics of the February 27 issue argue that the bond issue raised interest rates causing a loss to the taxpayer. This criticism is correct for the following reasons.  First, as noted above if only the originally offered amount was raised the rate would have been less than 10.5% as opposed to the 11.73%. Prime Minister Wickramasinghe in his statement to Parliament has noted that the rate of 11.73% was about the same as the rate paid for the previous 30-year bond issued on May 27, 2014. However, the comparison is not valid for two reasons. First, in May of 2014 the market interest rates were about 20% to 30% higher than those that prevailed in late February 2015. Second, the May 27, 2014 issue was only for Rs.2.0b. If the same amount were raised on February 27 the rate would have been less than 11.0%.

4) Allegations Regarding Perpetual Treasuries

1. That Perpetual had access to information that other dealers did not have, which enabled them to come to the 27 auction fully prepared to bid for bonds worth Rs 10.0b or more and also get the Bank of Ceylon to bid on its behalf for an additional Rs 3.0b.
2. That the Perpetual bids were at the higher end of the interest rate spectrum which would not make much sense if the total amount on offer was only Rs1.0b or even double that. Thus Perpetual had to be very confident that the amount that would be taken would be far higher than Rs 1.0b. The reason for this confidence could be that they had information others did not have.
3. That Perpetual sold large amounts of bonds in the market on February 26 when the market generally was under the impression that CBSL policy interest rates would remain unchanged as per the CBSL press release on February 24, and were not aware of the CBSL decision to scrap the 5.0% SDF rate that would have caused interest rates to rise and bond prices to fall.
4. That Perpetual purchased bonds in the market the following week (the interest rate having gone up, the price of bonds would have come down) thus making a massive profit.

Investigation

We set out below some of the matters that it would be essential to investigate;

1) Given that a high level meeting agreed on enhanced funding requirements on February 26, was the Central Bank Governor instructed to accept Rs 10.0b at the auction of February 27?

2) a) Why did the Central Bank on  February 27 abruptly jettison the commitment relating to the SDF made by it in its monetary policy review of February 24?

1. b) Was announcement of this change (to take effect on March 2) made before or after the auction of February 27? The importance of this question has already been discussed.
2. c) It must also be investigated as to who took this decision, and when, and also how this was revealed, when, where and to whom. What was the role of the Monetary Board in this sequence of events?

3) As regards the auction on February 27, it would be necessary to investigate

1. a) Why were the primary dealers who were readying themselves for the bond auction scheduled for the February 27 not informed of the change in the bid amount (from Rs 1.0b to Rs 10.0b), so they could amend their bids.
2. b) All bids made at the auction by all primary dealers. It would then be clear whether any dealer or dealers bid for amounts vastly in excess of the Rs 1.0b which most brokers are reported to have been expecting.

If in fact one or a few dealers only bid for these vastly enhanced amounts, the basis for so doing could be clarified.

4) As regards the allegations regarding the trades Perpetual made before and after the auction of February 27, it would be necessary to investigate the trading activity of all primary dealers in the days before and after February 27. Only if the activities of all bond dealers are examined would it be possible to determine whether any particular company/companies could be considered to be an outlier or outliers whose activity could only be understood as being prompted by inside knowledge.

An important point regarding insider trading is that among say the Sri Lankan primary dealers, there may be those who are canny enough to discern unexpected market activity of their fellows, and follow the same behavior pattern in the expectation of making profits for themselves. This would be so if they know that the trendsetter is one who very likely is acting on the basis of knowledge to which only s/he is privy.  Therefore in investigating a pattern of purchases or sales, it would be necessary to determine who first started either the selling or the buying.

These are the basic matters which present themselves for investigation on the basis of the known facts and allegations as to what happened before, during, and after the bond auction of the February 27. The credibility of any investigation would depend on whether these matters are in fact fully and transparently investigated and the findings and conclusions of the investigating committee are made public.  If wrongdoing is exposed, stringent action should be taken against those responsible.

Implications

The voters of this country changed the government on January 8 because they could no longer bear the injustice and corruption of the Rajapaksa administration. Going by the daily revelations of corruption, deceit and worse that have come to light in the last ten weeks, the people were right in their judgment. They also believed in Mr. Maithripala Sirisena’s promise to usher in a new dawn for the country with Yaha Paalanaya.

Those of us who are old enough to recall J R Jayewardene’s 1977 promise of a Dhaarmishta Samaajaya may be rather cynical of what politicians promise. However, about one third of the January voters were not even born in 1977. Only about one in five voters who voted on January 8, voted in 1977. Thus a large majority probably have more faith than some of us who are older, and believe that Yaha Paalanaya would become a reality after January 8. The Treasury bond scandal that we tried to explain in this article appears to have caused a palpable sense of disappointment if not dejection among these voters. However, it is not too late to put matters right.

Appointing three lawyers who have no expertise in the subject to inquire into the issue has not helped. Adding insult to injury the individuals have been affiliated to the ruling UNP at one time or the other and that leaves room to question their credibility. To minimize the damage a new committee with relevant expertise should be appointed.

This episode highlights the need for strengthening the capacity of the Central Bank. It also demonstrates the need for a thorough review of laws and regulations governing the financial sector with the goal of creating a new regulatory framework that suits the 21^st century.

However, any laws and regulations or any sparkling new institutions could be undermined by a culture of corruption. Yaha Paalanaya has opened public space for criticism of the powers that be. This is a major achievement of the new government. The new administration could further strengthen democracy and improve the welfare of the nation by being more responsive to public concerns and criticisms and, as a matter of priority, combating the culture of corruption, which presently seems entrenched in Sri Lankan society.