This is the third article in this series. The first on 06.02.2019 covered auctioning and pricing of government securities, i.e., Treasury bills, Treasury bonds, Rupee Loans, Sri Lanka Development Bonds (SLDBs) and International Sovereign Bonds (ISBs), that are issued to borrow in open market. The second on 13.02.2019 outlined selected policy milestones involved in developing a debt market during the past 80 years.
The government can borrow even without developing a debt market. However, the development of govt. debt market is required, not simply for the government to borrow in the market with transparency, price discovery and liquidity, but also to serve as the core of a deepened financial system to keep the economy active and financial system stable. The economic role of a developed govt. debt market is outlined as follows.
Facilitating the Fiscal Policy
In many countries, fiscal deficits are maintained to promote economic growth and employment. Fiscal deficits which are economically significant volumes ranging from 5% to 10% of GDP in Sri Lanka stimulate the private sector in the economy. Such fiscal deficits need financing mobilized from wider and deeper sources as the dependence on few lenders/arrangers is highly risky for any borrower. In finance/credit management, the concentration risks need to be minimized. Unless the debt market is deeper, the fiscal policy will be at great risks where economically unfriendly taxes that are raised to finance deficits would kill the economy. In developed countries, the fiscal stimulus by cutting taxes and raising debt from the market to finance fiscal deficits is considered as a good macroeconomic policy.
Therefore, the transparency, price discovery and liquidity gained through market development will help the fiscal landscape to be kept relevant to the needs of the economy. Issuance of different maturities of debt (3 months to 30 years) will help the government to better manage the fiscal front and the economy by combining the expenditures financed by debt with their economic returns and tax income receivable in future.
Offering Risk Free Investments to wider public
Govt. debt is considered as the most credit risk-free investments because governments have powers to raise funds for repayment of debt although there can be debt defaults at times as reported from several countries who did not manage the fiscal front prudently. Everybody, individuals, investors and corporates, look for safer investments as a part of their wealth at different risks. They diversify their wealth among several assets and govt. debt/securities. They also reprofile/rebalance asset/investment portfolios from time to time by taking into consideration of risks and returns between govt. securities and other assets. Therefore, the development of govt. debt market with the transparency, price discovery and liquidity will help wealth management at preferred risk appetites.
Facility of Yield Curve/Term Structure
All economic activities take place looking for returns based on underlying risk levels. Therefore, the economy needs benchmarks for returns at lowest risk. The return/yield on govt. debt is considered as the benchmark as the govt. debt is considered to be the most credit risk free investment. Therefore, development of govt. debt market would provide a wide spectrum of securities with active trade/investments in both primary and secondary markets. Interest rates/yield rates across all govt. securities with maturities from 3 months to 30 years (Sri Lankan law provides for issuance of securities up to 60 years) are the benchmark returns for various economic activities inclusive of investments and credit of respective maturities.
Therefore, the yield curve which is the plot of yield rates across all government securities traded in the secondary market on daily basis is the benchmark term structure that helps the private sector to price the risks involved in their credit and investments. Accordingly, risk premia over the relent point/sector of the yield curve are charged to fix the interest rate/rate of return on private credit and investments based on their risks. When the govt. debt market is developed across international markets in hard currencies such as US dollars, the sovereign yield curve will help the country’s international capital flows too. Therefore, the yield curve plays a key role in finance theories and their real-world applications.
The yield curve will emerge and be active only if the govt. debt market is developed and active. Otherwise, interest rates/returns applied on economic transactions will be highly individualistic and artificial for the financial system and economy. This prevents the efficiency in resource mobilization and utilization. In developed market economies, the shape of the yield curve (i.e., flatter or steeper) is a predictor of the future economic growth.
Facilitating development of Private Financial Markets
Govt. debt market is the foundation of the financial system and markets. Govt. securities market is the conduit for all other financial/credit markets which interact with the govt. securities market for portfolio management. Meanwhile, govt. securities are the best quality collaterals for private credit. Yield rates on govt. securities are the best benchmarks to determine both fixed interest rates and floating interest rates (i.e., 6 months Treasury bill yield plus a margin) in private credit/debt markets.
As a result, private debt securities market will develop alongside the govt. securities market supported by transparency, price discovery and liquidity. The development of private securities market is necessary to deepen the financial/credit pyramid to enable businesses to innovate by taking more risks as the bank credit market is restrictive due to prudential and systemic concerns. The development of private financial markets cannot be expected without developed govt. debt markets.
Providing a risk-free conduit for the conduct of Monetary Policy
The conduct of the monetary policy to regulate interest rates, exchange rates, credit and money supply is carried through or based on govt. securities market in several routes.
Basics
First, central banks print money to inject monetary liquidity to the economy through the purchase of govt. securities in the market as they are the most credit risk-free. They also grant credit to banks on collaterals of govt. securities. Therefore, the source of initial money or credit to the economy is largely based on govt. securities.
Second, central banks monitor the yield curve to regulate interest rates, i.e., short-term, medium-term and long-term, as they consider suitable for the growth of the economy. Accordingly, central banks intervene in the yield curve in open market in order to drive interest rates in the economy as they prefer. The intervention vehicle is the buy and sell of government securities of particular maturities in the secondary market (i.e., open market operations – OMO). Although central banks can directly control interest rates on bank deposits and loans, the global best practice has been the OMO. For example, when the economy needs long-term investments to promote the growth, the central bank intervenes in the long-end of the yield curve to reduce yield rates (flatten the yield curve) so that long-term interest rates in private credit markets also will decline while raising the collateral value of long-term govt. securities to increase the volume of credit.
Country Experiences and Practices
The monetary policy followed in Japan since September 2016 is based on yield curve control, i.e., keeping the 10-year govt. securities yield around zero, to promote long-term investments in the economy. For this purpose, the Bank of Japan keeps on buying 10-year govt. securities to maintain the yield rate around zero. The “Operation Twist” of the US Federal Reserve in 2011/12 involved in selling of short-term govt. securities and using the proceeds to buy long-term government securities in order to bring down the long-term yield rates and interest rates. This was one of monetary policy measures adopted to help recovery of the US economy from the global financial crisis 2007/09. A similar twist was adopted in 1961 too.
Central banks in advanced economies heavily used OMO in govt. securities as part of quantitative easing/asset purchases as policy interest rates were kept around zero during the last decade to facilitate the recovery of economies from the global financial crisis. First, they purchased huge volumes of govt. securities to pump new money to the economy to raise the liquidity and spending in the economy.
Second, they exchanged govt. securities for risky private securities held by banks and corporates to increase their liquidity and solvency. As a result, these banks and corporates who were dying with risky private securities (subprime securities) without a market could sell those to central banks at discounts and receive govt. securities in return. This helped a large number of business firms to survive the financial crisis.
In addition, massive OMO purchases of govt. securities by central banks facilitated the governments to extend fiscal stimulus. If not for such fiscal stimuli, the world economy today would be suffering from the first depression in the century.
In the event govt. securities markets are not active and deep, central banks have to depend on private securities to carry out the monetary policy. As a result, they will confront bankruptcies due to risks underlying private securities. Therefore, financially safe and stable central banks prevail because of govt. securities markets.
OMO Authority for the Central Bank of Sri Lanka (CB)
Same principle and system of OMO are stipulated in the Monetary Law Act (MLA) for the CB. One of the two purposes of OMO as per MLA is to increase the liquidity or stabilize the values of govt. securities in order to promote private investments in govt. securities and to prevent or moderate sharp fluctuations in the quotations (i.e., bid prices) of govt. securities without altering fundamentally movements in the market resulting from basic changes in the pattern or level of interest rates. The CB is authorized only to use govt. securities and CB securities for OMO. This mandate corresponds to the yield curve control and development of govt. securities market through the monetary policy.
However, the CB’s policy rates corridor-based OMO which is claimed to be an improved version of monetary policy is in gross violation of relevant provisions of the MLA and best practices. It is revealed that the CB has used govt. securities issuances/management along with EPF management to control interest rates for the purpose of monetary policy without any yield curve in place of standard and lawful OMO.
Providing a key route for inflow of Foreign Capital
As international investors generally look for govt. securities with different risk profiles supported by international credit ratings as part of their investment portfolios, govt. securities market is the first conduit to attract foreign investments. Countries like Sri Lanka who run on structural BOP deficits require foreign capital to finance such deficits.
In fact, the CB promoted foreign investments in Rupee securities, SLDBs and ISBs for the sole purpose of attracting foreign investments/exchange to build the CB’s foreign reserve for BOP purposes without implementing the monetary policy to promote a healthy trade balance as provided for in the MLA. Therefore, this short-sighted foreign reserve policy has partly caused the present govt. debt problem.
Many countries have gradually opened up their govt. securities markets to attract foreign investments. Such foreign investments also promote both govt. securities and private financial markets as foreign investors move funds between these markets to maximize returns. Therefore, foreign investments will help deepen the markets through liquidity, new products and governance. Even advanced market economies finance their fiscal and BOP deficits through such foreign capital inflow. It is unknown why the CB announced a 50% curtailment of the threshold opened for foreign investments into Treasury bills and bonds. This curtailment is like treating the spine to cure the swollen legs.
Liquid Assets to Banks and Financial Institutions
It is customary that banks and financial institutions hold a reserve of govt. securities to manage their liquidity risk such as repayment of customer liabilities (deposits, insurance claims, short-term debt, etc.) while earning a safe return. This practice helps protect the customer trust in them. This is possible only if the govt. securities market is active and liquid. Otherwise, banks and financial institutions have to hold a large volume of idle cash for this purpose as private assets are risky and illiquid. Regulations also have prescribed govt. securities as a liquid asset. Insurance regulations have prescribed minimum rates of investments of technical reserve and long-term insurance funds of insurance companies to be made in govt. securities. In turn, such regulations also help promote govt. securities markets.
Does Sri Lanka enjoy economic benefits of Govt. Debt Market?
Data show that nearly Rs. 7 trillion or 68% out of total outstanding govt. debt (Rs. 10 trillion) as at end of 2017 has been raised by the CB through issuance of govt. securities. However, despite several policy initiatives taken to develop the debt market during the past 80 years, present difficulties in debt sale and repayment, grave statutory violations and market abuses as publicly revealed from govt. securities market reflect poor market development. Therefore, Sri Lanka does not enjoy any of above outlined economic benefits of govt. debt market, except CB’s limited OMO and credit delivery.
The manner in which the CB has acted as the issuer, debt manager, EPF manager, regulator and supervisor is also alleged on publicly witnessed abuses. In response, certain top CB officials who caused those abuses appear in public, possibly with 10-years-back-dated legal opinions, to justify the validity of privately issued securities in the past decade. The interpretation of words such as “any application or bids” now to establish the authority for private issuances of govt. securities to raise several trillions of funds on regular basis in the past in violation of all good debt market and financial control standards is also an abuse of public accountability. John Exter, the father of the CB and Sri Lankan monetary system, stated in his report that good central banking is less good law than good practice. Probably, international economists of the CB who behaved like reborn-Adam Smiths may have followed Adam Smith’s market philosophy of “self-interest” to govern the public debt market through private issuances of govt. securities.
The Sri Lankan Parliament also was dissolved on such interpretations of legal words provided by top legal experts in the country. However, the national debt overhang created by unlawful issuances of govt. securities by the CB is worse than the unlawful dissolution of the Parliament as we do not have any recourse to adverse economic effects of trillions of debt abuses.
Laws provide for a set of discipline to public officials to exercise a corded discretion to make public decisions. They must act within what laws stipulate. However, as laws are too fair to punish violators, they continue to enjoy public powers and privileges that cause further economic damages to the public.
At final count, as John Exter stated, the government must take the responsibility of all CB’s policies. As the first step, the government must investigate into how much it received out of Rs. 7 bn face value of debts raised through issuance of govt. securities, who got the balance funds, public accountability of the procedures adopted for issuances, how such debt proceeds were managed in the fiscal front to generate future revenue streams to repay debts and why the debt market was not developed, despite several policy initiatives taken during the past 80 years.
If the government remains sleepy by letting the CB to continue its past debt issuance practices by expecting so-called forensic audits to fix all those problems, the eventual outcome will be the public bankruptcy caused by a burst of a debt bubble in the next decade because the network of private issuance/sale of debt without developing a wider market could well be a form of Ponzi funding schemes that cannot get away without a collapse/burst.
(The writer is a former Deputy Governor of the CB and a chairman and a member of 6 Public Boards with nearly 35 years of public service. He authored 5 economics and financial/banking books and more than 50 published articles.)
Add new comment