Mahendran responds to Wijewardena’s article

Apropos the commentary by W.A. Wijewardene in your edition of Monday 11 July, entitled ‘Direct sale of Government securities; demon of servant?’ former Central Bank Governor Arjuna Mahendran has sent the following response:

Mr. W seeks, yet again, to justify the unusual procedure adopted by the Central Bank after 2008 of privately placing the bulk of Treasury bond issues with primary dealers. This is in complete contrast to the internationally tried and tested method of having open competitive auctions to determine price or quantity of bond issuance, with a limited 5% quantity for post-issue ‘tap’ placements at the weighted average yield posted in the auction.

He relies on comments attributed to former Governor A.S. Jayewardena where the latter had cautioned against oligopolistic practices of primary dealers, to justify the curious local obsession with private placements. This prescription seems excessive to me, and worse than the alleged underlying malady. Combating oligopoly is an issue which comes within the regulatory realm of market supervisors. The Central bank supervisory departments have considerable powers to deal with anti-competitive market practices.

To justify the suppression of market forces on the basis of alleged anti-competitive market practices is to throw the proverbial baby out with the bath water. The fact is that in February 2015, secondary market yields for 30-year bonds had been driven down to unrealistic levels as a result of the public debt department offering them at artificially low yields, viz. 9.5%, through private placements (PPs). Over 80% of Treasury bond issuance in 2014 had been issued through PPs.

As a consequence, the demand for these bonds had reduced to a trickle. This was why the monetary board decided to hold an auction in the last week of Feb. 2015 to re-establish price discovery on these bonds at the furthest extremity, viz. 30 years, of the SL Rupee sovereign yield curve.

The Sri Lanka rupee has historically depreciated by 7% per annum against the USD so it would be logical for investors to expect a yield of more than 7% to adequately compensate them for their risk. Hence the yield was fixed at 12.5% pa for the auction using standard formulae.

It was no secret that the Treasury has large repayments in the month of March. Tax payments start coming in after the new budget proposals kick on 1 April each year. It is therefore not a coincidence that market rates rise aggressively in March each year. This happened yet again in March 2016. To accuse primary dealers of bidding up yields in anticipation of such large funding requirements is to apportion blame on the wrong market participant. 

The Treasury has to come up with an effective cashflow management system to iron-out these lumpy repayments. This is yet to happen. Until such time the alleged oligopolists will cause occasional spikes in yields. That is how a market is supposed to function. Mr W and his ilk prefer to kill the market mechanism to avoid the Treasury paying the price for inadequate cashflow management. This remedy therefore confuses the symptom of the disease with the real underlying malady.

By forcing the Treasury to pay high yields in periods when its demand for funds surges is the only manner that an independent Central bank can enforce market discipline on egregious government borrowing. On the other hand, the proposal to effectively rob captive investors such as the EPF, SLIC and state banks and force them to subscribe to low-yield private placement of bonds is not a solution; it simply robs depositors in these captive institutions of an adequate return.

What happened in the last week of February 2015 was that the Treasury had given prior notice of a funding requirement of Rs 13.5 b on 1 March 2015. The private placement window had only been able to raise Rs. 3.5 b in the week ending Friday 27 February 2015. It was thus decided to accept the balance Rs. 10 b from the auction where bids of Rs. 20 b had been placed for the Rs 1 bn. of issuance advertised.

This decision has come in for much criticism. Suffice to say that the government was severely strapped for cash at the time. In the same week the Cabinet Committee on Economic Affairs requested three Senior Ministers of the Government to visit the Central Bank on 26 February 2015 and explore ways and means of raising an additional Rs. 75 b to re-commence the large number of stalled road construction projects across the country.

Furthermore, market participants were already anticipating a large Rs. 122 b repayment of borrowed funds coming due in the third week of March 2015. Thus, the market was acutely aware of the sudden surge in funding needs of the Government beforehand. To allege that this was insider information is to miss the point. Primary dealers and fund managers employ multitudes of research staff to gather such information. Any educated observer could have easily gleaned the real possibility of a funding crunch for the Treasury in March 2015, or for that matter, March 2016 as well.

It has been contended by some commentators that the Central bank should have taken a massive bank overdraft to raise the large amounts needed. To do so would have raised interbank and prime lending rates and affected ordinary bank borrowers. All such comments, in any case, are made with the benefit of hindsight. They ignore the reality that policy-makers usually have to make quick decisions with a limited amount of information in circumstances such as that which prevailed at the 30-year Treasury bond auction of 27 February 2015.

Suffice to say that the system of auctioning Treasury bonds has been a success since February 2015. Even as foreign investors sold out of local bond and equity markets in 2015, the bond market was able to tap a large pool of domestic savings to fund the Treasury’s burgeoning funding requirement. Most importantly, the market mechanism has been able to signal market participants’ expectations of future economic variables effectively.

This can only be construed as a step towards a better functioning of financial markets and the overall flow of funds through the economy.

Arjuna Mahendran