Thoughts on Central Bank Red Alert

By W.A Wijewardena

Central Bank making losses in two consecutive years
There is an ominously dangerous Trojan horse that has been placed in the Central Bank by its previous administration led by the so called Monetary Board which still continues in perpetual succession. That horse is the mounting losses it has made consecutively for two years in 2013 and 2014 under its management. The implications of the Bank’s losses in 2013 amounting to a staggering Rs 39 billion – about half a percent of GDP – when its comprehensive operations are taken into account were discussed by this writer in an article in this series under the title ‘The questionable governance when a loss-incurred Central Bank has made a profit transfer to the government’ Now the latest Central Bank Report for 2014, published recently, has disclosed that the Bank has continued to make losses even in 2014. Accordingly, the Bank’s ordinary operations have resulted in a net loss of Rs 32.3 billion in 2014 as against a loss of Rs 24.3 billion in the previous year on this account. However, these ordinary losses have been somewhat partly offset by an increase in the fair value of securities held by the Bank bringing down the net loss to Rs 21.6 billion in its overall operations. Three salient features could be noted in this alarming regression of the Central Bank in the two years under reference. First, the losses in ordinary operations have increased from Rs 24.3 billion in 2013 to Rs 32.3 billion in 2014 posing a serious threat to its risk management. Second, the losses in 2014 have spread to both the foreign and domestic operations of the Bank whereas in 2013, they were confined only to its foreign operations. Third, over the two year period from January 2013 to December 2014, capital funds of the Bank has depleted from Rs 182.5 billion to Rs 81.7 billion marking a drastic reduction of Rs 101 billion or 1% of GDP. A Central Bank degenerating to such a financial depth puts the nation – the collection of its stakeholders – on red alert.

Smart accounting practised in 2012 to show thumping profitability in Central Bank
The story of the Central Bank making losses in 2013, as discussed in the above mentioned article is as follows. In 2012, there was smart accounting done by the Central Bank to show in its final accounts a thumping profit by selling its gold reserve at high prices just before the end of the accounting year. Accordingly, the gold reserves which had been bought by the Bank in the past at low prices were sold at the prevailing market price of about $ 1600 per fine ounce. According to the statistics maintained by the World Gold Council, the total of such sales in 2012 had amounted to 10.4 tons of gold. With these sales, the Bank had made a huge profit, unprecedented in its history, of Rs 50 billion out of its foreign exchange operations. In order to show that its gold reserve has not depleted, the Bank had repurchased gold at the prevailing high price of $ 1600 per fine ounce mainly in December 2012. The World Gold Council data show that the Bank’s total purchases in 2012 had been 13.8 tons and out of that, 9.8 tons had been purchased in December alone. Thus, as at the closing of accounts in 2012, there was no depletion of the gold reserves. This was a wild speculation done by the Central Bank that the gold prices would continue to go up in the market enabling it to make a similar killing in 2013 as well.

Market defeats the Bank’s smart accounting
But market prices of gold changed in the opposite direction in 2013 reducing the price from $ 1600 per fine ounce in the previous year to $ 1200 per fine ounce as at the end of 2013. When the estimated gold reserve of 22.95 tons as at the end of 2013 was revalued at the new prices, it resulted in a massive mark to marker loss for the Bank. Thus, the smart accounting done by the Central Bank in 2012 was completely defeated by the market in 2013. Despite the Bank making a thumping loss in 2013, the subsequent information has revealed that it has made a profit transfer to the government by recalculating profits in terms of the provisions in the Monetary Law Act or MLA. Here, the Monetary Board appears to have read MLA not in its spirit but in terms of the literary meaning it has conveyed. This is not what a Monetary Board expected to exercise prudential diligence in its decision making should have done.

Need for exercising prudential diligence by the Monetary Board
In 2005, when the Bank made a loss of Rs 6.2 billion due to the losses arising from the revaluation of foreign exchange reserves at the prevailing exchange rate, the Board was required to decide whether a profit transfer should be made to the government. In this instance, the government had included a profit transfer of Rs 2.5 billion from the Bank in its budget for 2006. However, exercising prudential diligence, the Monetary Board headed by Governor Sunil Mendis decided not to make a profit transfer to the government despite the continuous demands of the
Treasury. The position taken by the Board was that when the Central Bank has made losses, it was against the spirit of MLA to make a profit transfer to the government. However, according to the data published in the Central Bank Annual Report 2014, a transfer of profits amounting to Rs 11.5 billion – consisting of two parts – has been made by the Bank in that year. One was a profit transfer of Rs 3 billion based on its financial performance in 2013 which was a loss but recalculated as a profit by technically following MLA. The other was an advance profit transfer of Rs 8.5 billion out of the profits to be made in 2014. This advance profits transfer, as per the disclosure in the accounts, has been made after the external auditors had certified that the Bank would make profits in each of the quarters involved. The Monetary Board had taken cover behind these audit certificates to justify its action. However, in doing so, it had failed to exercise prudential diligence as the Monetary Authority of the country.

Prudential diligence requires Monetary Board to build the Bank’s capital reserves
What is this prudential diligence which the Board has to exercise? That is to maintain its long term solvency by building up its capital reserves as an additional cover of the money it has issued. In terms of MLA, the Bank should build reserves first out of profits before it would consider making a profit transfer to the government. This restriction has been placed on the Monetary Board by law, as John Exter has argued in his Report to the Government of Ceylon on the establishment of a central bank known as the Exter Report (p 22) to prevent the Central Bank from making profits through its domestic operations and generating a secondary expansion of money in the economy. This is because in the first instance, it has already created money and in the second instance, it would boost up that money. A profit transfer through such a mechanism would jeopardise its goal of stabilising prices and the exchange rate. However there is another reason for the Monetary Board to be cautious of transferring profits to the government. That is, if the capital funds of the Central Bank are being depleted, it should not hasten such depletions by transferring profits to the government.

The gradual depletion of Central Bank’s capital funds should put the nation on red alert
In terms of MLA, the Central Bank should have a capital cover equivalent to at least 15% of its domestic assets. The objective here has been to restrict the unwarranted growth of the central bank’s domestic assets and thereby prevent the erosion of the protection given to the holders of money it has issued. In this context, given the unanticipated episodes of financial turmoil today, the maintenance of the minimum requirement as the protective cover for the money it has issued is considered inadequate. Accordingly, the Monetary Board led by Governor A S Jayawardena decided in 2002 as a part of the Bank’s modernisation programme to increase this cover over the time up to 100% of the Bank’s domestic assets. This target was reached in 2007 when the capital funds amounted to 103% of the domestic assets of the Bank. However, since then, it started falling reaching 45% in 2011 and 41% in 2013. In 2014, this has fallen to 19% barely above the minimum legal requirement. It is strange that the Monetary Board which is expected to exercise its prudential diligence did not notice this decline in the capital funds of the Bank when it decided to make a profit transfer of Rs 11.8 billion in 2014. In 2015, the budget of the government expects the Central Bank to make a profit transfer of Rs 23 billion to the government. It is interesting to see whether the Central Bank would accede to this request by jeopardising its capital base and thereby driving it to eventual bankruptcy.

Losses in 2014 are from both foreign and domestic activities
The vulnerable position of the Central Bank today can be ascertained by analysing the losses it has made in 2014. It can be seen that, since the Bank’s monetary policy has not been changed, the seeds that contributed to losses in 2014 are still pretty much present looming over its financial performance with a gloomy shadow in 2015 as well.
The losses in 2014 have come from both the external sector and the domestic sector of the Central Bank. Though the interest income from foreign investments has increased in Rupee terms from Rs 18 billion in 2013 to Rs 22 billion in 2014, after correcting for the exchange rate depreciation it has increased in Dollar terms only marginally from $ 138 million to $ 168 million. Thus, the overall portfolio has generated more or less the same rate of return on average at 2%. Given the interest rate decline close to zero in the Euro Zone in the current year and no prospect for rate hikes in USA in the immediate future, the Bank is in a very vulnerable position to increase its interest yield on foreign investments. In this scenario, it is likely that the foreign operations of the Bank may result in a loss in 2015 as well.

Central Bank’s net interest outpayments to commercial banks
The net loss on foreign investments amounting to Rs 8.5 billion has been reinforced by a bigger loss on the domestic side of the Bank’s operations. There, the major contributor to the loss has been a massive interest outpayment by the Bank amounting to Rs 17.7 billion. This is mainly due to the new monetary policy adopted by the Bank in early 2014 in which it did away with using government securities for its open market operations to siphon off the excess liquidity in the market. Instead, it introduced a new standard deposit system under which excess banks were to place their excess money with the Central Bank at 6.5% per annum. Since the country was in an excess liquidity position throughout the year, this new policy has resulted in a massive interest outpayment in the Bank. As such, while the Central Bank has incurred a massive loss, it has enabled the commercial banks to report thumping profits. The total of both the foreign and domestic operations of the Bank have brought in a net operating loss of Rs 20.3 billion in 2014 as against a net operating loss of Rs 12.8 billion in 2013.

An ominous increase in consultancy fees
These operating losses in 2014 were further augmented by a substantial increase in the operating expenses of the Bank. Accordingly, the operating expenses have increased from Rs 9.4 billion in 2013 to Rs 11.3 billion in 2014. The main culprit? It is not the salary bill of the Bank which has in fact declined from Rs 5.5 billion to Rs 5.0 billion between the two periods. The culprit comes from a massive increase in the Administration and other expenses of the Bank which have more than doubled from Rs 2 billion in 2013 to Rs 4.1 billion in 2014. In this category, as a note to the accounts has revealed, the increase has exclusively been due to an extraordinary expenditure called ‘Consultancy, Communication, Advisory and Professional Fees’. These expenses which have been a pittance of Rs 17 million in 2013 have shot up to Rs 2051 million in 2014.

Have the consultancy fees brought value for money?
The nation has a right to know what these consultancy, communication, advisory and professional fees are and what benefits they have brought to the country. The Monetary Board which is expected to set an example to other financial institutions about the proper disclosure policy cannot just hide it in a brief note to the accounts. The note is so inconspicuous that only through much labour that one could find it in the accounts of the Bank. The auditors too, both the Auditor General and the private external auditors hired by the Auditor General, cannot just certify it and remain silent because they are required to do an audit on the ‘value their client had received for the money he has spent’. Though the Bank has been silent on this massive extraordinary expenditure, one could speculate that it may be in connection with what was reported in the media as Bank’s hiring some US media firms to do propaganda for the Bank and the former Managing Director of the IMF as a consultant. Such hiring can be done by the Bank only for its main objectives, namely, economic and price stability and the financial system stability, and not for any other purpose. The Monetary Board, if it acts in the best interest of the good governance it is to establish in the financial sector, owes the nation a detailed explanation.

Central Bank’s pension fund too is in peril
The Bank’s total losses should be more than what has been reported since the gap of Rs 3.5 billion in its Pension Fund has not been filled in its accounts for the year. This has made the Bank’s pension fund too vulnerable to failure bringing a huge credibility risk on the Bank.

Depletion of capital funds
The Central Bank’s capital funds have depleted to a bare minimum today. If this continues and its networth falls below the minimum statutory requirement of 15% of its domestic assets, the taxpayers have to bail out the Central Bank. This happened in the case of the Central Bank of the Philippines in early 1990s (available at: http://www.ft.lk/2013/12/02/even-mighty-central-banks-can-go-broke-if-imprudent-policies-are-adopted/ ). But bailing out of bankrupt financial institutions has now become costly to taxpayers. Instead, it has been suggested that it be replaced with a ‘bailing-in’ strategy under which the costs are to be passed onto those inside banks (available at: http://www.ft.lk/2013/05/27/handling-bankrupt-banks-gone-are-the-bail-outs-and-enter-the-bail-ins/ ). What it means is that the Monetary Board should be directly accountable for the unsavoury regression of the Central Bank which was made a strong institution through the modernisation project implemented in the Bank under the leadership of Governor A S Jayawardena.

Monetary Board members should know their responsibility to the nation
There is a learning lesson out Central Bank’s financial fiasco. That is, as this writer had argued in a previous article in this series, those who aspire to become the Governor or Monetary Board Members should know how to read MLA in its spirit and not in mere literary terms. It also places a responsibility on those who appoint them to select such members based on merit rather than on political loyalties.

(W.A Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com)