Opinion: Perpetual and the problem of unfettered capitalism

By Chamath Ariyadasa

Questions about rampant capitalism are raised not just in Sri Lanka but in all developed financial markets. Hence, calls for a more subdued, socially conscious process reverberate here as well, and these arguments are important.

Once we set the rules, the private sector steps in to maximise profit — acting within the neoliberal agenda. That is the system we have created for ourselves, and our private sector is no exception.

But, like elsewhere, the nexus between the private sector and government is a complex one, and some believe it has gone too far.

The administration of regulations in Sri Lanka is arguably poor, which means our companies operate within both the black and white, as well as the grey areas of the law. And they don’t disclose information when they don’t need to.

This is why dialogue and negotiations with market participants, and fine tuning of regulations, has to be done constructively and on a continuous basis — but I may be getting ahead of myself here.

Along with profit maximization is the hallowed concept of the private ownership of land and capital, a natural right, it is believed — this, together with political systems of hierarchy and subservience, means the trifecta is complete.

Of course we will be called “communists” by our democratic allies, if we question any of these hallowed principles, so this writer won’t go there just yet.

The urgent matter at hand is whether we forge our own path in negotiating a just economic system, and whether we “name and shame” a few companies while doing so — these days, at least, it seems just one company in particular – or are there alternatives?

Facts of the case
While the facts of the matter are murky, what can be said clearly is the following:

Many argue there has been complete collusion, not just between this company and the hierarchy of the Central Bank, but also at the highest levels of government. This enabled the company, Perpetual Treasuries, to make 10 billion rupees in tax-free profits, which is a tenfold growth during a 14-month period.

The allegation continues that there was collusion with state pension funds, and the Central Bank, the designated supervisor and regulatory body, deviated from its regular function of monitoring and regulating the bond market, during this period.

Perpetual Treasuries, as a result, borrowed from the Central Bank repo window and other sources, and through highly leveraged positions, took positions that enabled massive profits, not once, but repeatedly.

But there are other arguments, and these deserve due consideration too.

Counter arguments
Primary dealers, according to the current state of regulation, are allowed to leverage up to 10 times their capital.

Although many companies would not take the risk of wiping out their capital, Perpetual Treasuries, it seems, took highly leveraged positions through various options.

They either did this with perfect information, or they could predict the movement of interest rates in the illiquid and one-sided bond market, or they were willing to gamble their capital, given their view on interest rates.

It’s worth noting that some companies do this in developed markets too. However, the supportive stance of state pension and long-term funds is essential to complete the equation.

What we do know
Even non participants in the Sri Lankan bond market can say a few things with clarity.

The government had a predictable and massive budget deficit last year. In fact, Sri Lanka runs twin deficits every year.

Tax revenues were predictably lower, government spending escalated, and a sharp outflow of foreign funds from the bond market, to the tune of 1.5 billion dollars thanks to the exit of Franklin Templeton, blew a huge hole in the balance of payments.

Given the heavy domestic and foreign borrowing requirement, (during an election year in which rates apparently don’t go up), the sharp decline in foreign reserves, and the need to resort to IMF funding and to protect the currency, the pressure on interest rates were clear — they were heading up.

Bit more analysis
With a bit of analysis, one can reach a few more conclusions about the situation in Sri Lanka.

Given the massive annual borrowing requirement of the government, interest rates would continuously spike upwards if left to market forces. The sheer volume of the borrowing program means the market is, arguably, one sided.

Without the savings and participation of long term funds, especially the state pension, savings and insurance funds, the Sri Lankan government would not be able to meet its annual borrowing requirement.

The amount of savings the government can access locally, outside of captive sources, is rather small. This means the government has to compete with the private sector for these funds.

This competition in the secondary market is what gives the semblance of a demand and supply situation, the price of which is called market interest rates.

In other words, with the captive involvement of state funds, Sri Lanka does not have what can be called a properly functioning market.

Captive funds continuously roll over their portfolios and purchase treasury bonds. If they do not do so, the government would go bankrupt. At the same time, the funds would not be able to manage their massive portfolios.

The EPF portfolio, for instance, manages 1.8 trillion rupees which are mostly in treasury bills and treasury bonds.

With predictable pressure on interest rates, and predictable buyers for bonds, a market participant may be able to map out a strategy by leveraging their positions, and arbitrage between short and long-tenure bonds — or so the argument appears to be from the Perpetual Treasuries side.

Theoretically, at least, this appears to be possible.

COPE report
According to the interim COPE report, the government funding requirement, expected for March 2015 in late February 2015, was to the tune of 261 billion rupees, an exceptionally high month — it would be met by issuing 89.6 billion rupees in treasury bills, and 172 billion rupees in treasury bonds.

The report doesn’t explain why this was an unusual month. But the month follows elections held in January, and several months of auctions not being held.

The then Governor Arjuna Mahendran approved raising 40 billion rupees through the issuance of 20-, 30- and 50-year treasury bonds, of 10 billion rupees each, and noted that EPF, NSB and SLIC should stabilize rates.

This was however not implemented as approved, the report shows. Actual funds received during the month of March amounted to 185 billion rupees. The implications of this shortfall are also not explained.

The report further states that central bank officials, who are unnamed, were worried that there was a risk of being unable to raise all the money in March by resorting to direct placements. The writer of the report concludes that these concerns were unwarranted.

The dismissal of the concerns of central bank officials, the lack of detail on these particular events, and the short statement recorded from the EPF, suggests possible bias on the part of the author.

What happened on Feb 27?
Mahendran subsequently explained, when speaking to media, that his general intention was to increase market participation in the bond market so as to build a more vibrant secondary market.

Maybe he suddenly upsized the primary auction bond issue on February 27th from one billion rupees to 10 billion rupees, for this reason, given the perceived shortfall in March.

In theory, at least, this is possible.

A careful market participant may have been able to guess that there was a serious shortfall in March, given the disclosures on the government borrowing program and maturity profiles.

They may then have aggressively bid in the hope of getting lucky.

The dominant argument, however, is that they had inside information that made this aggressive bet worthwhile.

Inside information
Given just how massively overstaffed and politicized the Central Bank is, it is possible that information suggesting that the issue would be upsized, leaked from somewhere else.

Information suggesting the issue would be upsized, as opposed to perfect information, may fall into a grey area on inside information.

Whether the break from procedure to improve market performance, and naiveté that his son-in-law’s company was suddenly highly active in the market, was what really happened –naiveté can also stem from bad advice — the real question here is whether there was inside information. And that too from the mouth of the governor.

The jury is still out on that, in my opinion.

50 basis point rate cut
The other significant allegation is that the 50 basis point cut in policy interest rates in April last year, by Mahendran, was to further the goals of this primary dealer.

By association, this allegation assumes the Finance Minister, the Prime Minister, and the Monetary Board all colluded on this decision, since our Central Bank is by no means independent.

According to the monetary policy statement that month, the decision was made to boost economic growth amid low inflation. While again benefiting those who hold a significant portfolio of bonds, it is possible that Sri Lanka followed what 20 other countries did.

The Finance Minister, who strongly favors low interest rates, may have been involved in this scenario.

Given the upward pressure on interest rates, and this strange policy cut, all market participants should have been able to position themselves vis-a-vis their expectation on future interest rates, and arbitrage short and long-tenure bonds.

Predicting interest rates
Predicting interest rates is not a science, but even this writer believes that uncertainty ahead of securing IMF funding would drive interest rates up. Positive news that Sri Lanka secured IMF funding would drive interest rates down.

Similarly, a two percentage point move in secondary market interest rates, after tightened policy, is likely an exaggeration, and there should be a dip, while a delay to VAT implementation should drive interest rates up.

News of a successful sovereign bond issuance would, similarly, put downward pressure on interest rates. Arguably, these were some of the major patterns, seen during the last year.

The other possibility, of course, is that market rates are continuously manipulated by the few players in the market — if this happens in stocks, it can happen in bonds.

Paper trail
At any rate, government securities is a highly regulated market, and there should be a paper trail within the Central Bank, and the state-owned funds, that explains the 10 billion rupee profit made by Perpetual Treasuries.

If there was a regulatory lapse, while these trades were being done, then there should be a paper trail on that too.

If the Central Bank did not have the necessary skills to monitor these highly leveraged trades, then it should admit to that, and boost its supervisory capacity going forward.

Economic priorities
To draw this long-winded and heated debate towards a conclusion, the opinion of this writer is that there are significant issues in every sector of the Sri Lankan economy.

SriLankan Airlines and Mihin have accumulated losses of 128 billion rupees, and total debt of 3.25 billion dollars, or 474 billion rupees, while cancellation of aircraft purchases recently cost the island 170 million dollars, or 25 billion rupees, in penalties, according to Reuters.

Perpetual’s 10 billion rupee profit pales in comparison.

If there is an economic first priority in the country, it is fixing this airline. There should be regular commissions and reports “naming and shaming” everyone concerned, from consultants to advisors, since “naming and shaming” seems to be the preferred way of doing things, and appears to gets things done.

Similarly, CPC, infrastructure and power sectors, bleed the country dry. The banking system is guilty of not providing loans to small and medium sized enterprises, while foreign banks play out Sri Lanka all the time, in everything from syndicated loans, to oil hedging contracts.

Primary dealer Entrust went bankrupt with over 10 billion rupees down the drain, CEO bonuses and perks, across the board, are not even discussed, while people clearly named in the Panama Papers have not been investigated.

There is a lot of “naming and shaming” that needs to be done — all these numbers are staggering.

What is happening in bond trading should certainly be investigated, but to make Perpetual “The” economic story in the country smacks of political bias. Despite every argument that this supported the government, the coalition was the big loser in these scandals.

Related to this is how we go about fixing the economy.

“Naming and shaming” is a rather archaic way of doing things, and a more evolved approach would be one of constructive dialogue.

This means discussions with market participants, and fine tuning of regulations on a continuous basis – arguably, there is no regulation in this island that doesn’t need to evolve regularly.

If individuals in the Panama Papers are investigated, give them the opportunity to bring back the funds, pay a penalty, and have a broad amnesty for what has been done. This seems the only way to ensure results.

Right now we have no results whatsoever.

While the option should be retained, heavy handed approaches don’t seem to work. Otherwise I have no qualms against them.

Going forward, Sri Lanka needs a new approach in dealing with all of these economic problems. It must also find a progressive approach.

( — Chamath Ariyadasa is the editor for Lanka Business Online. He was a bureau chief for Dow Jones Newswires in Colombo, and has an MA in the social sciences — )