CPC started hedging in early 2007 after the island's cabinet of ministers and a committee in which the central bank was represented, recommended hedging using zero cost derivative structures.
Hedge Push
CPC says it was instructed in writing to hedge.
"I will also show you the letter that I got from central bank where they are saying you have to hedge," CPC chairman Ashantha de Mel told reporters this week.
"They are pushing us. If we hadn't hedged, if oil went to 200 dollars (a barrel) my neck would have been on the block.
"They are telling us they are giving us the cabinet approval and telling us to hedge the oil so that the exposure in their central bank dollars will be within a manageable level.
That is what they are telling us."
CPC says it was hoping to bring stability to foreign exchange markets, the country and the utility itself, through hedges.
The state-run utility had found itself locked into contracts to buy about 900,000 barrels of oil, or a third of its imports till the middle of next year by purchasing specially structured positions that went against it, when oil prices collapsed.
CPC says it went into a leveraged 'zero cost' structure where it did not have to pay an upfront premium because it did not have a mandate to do so. If oil prices went up, CPC would have got oil at a fixed price for three months.
But when the position went against it, CPC had to buy double the quantity till the middle of next year. Banks that constructed the hedges insist that there was no mis-selling.
"For one thing we have to try and control the foreign exchange outflow," de Mel said.
"If oil is over 100 dollars a barrel we have a big problem in trying to settle these bills because, as you know the total reserves in the country are not enough to pay this year's oil bill which is over 3.5 billion dollars.
"Our reserves are also in a similar area.
"
Macro Balance
The oil bill had been frequently blamed for foreign exchange problems in the island, though the island's capital imports in most years had exceeded oil imports.
No one has taken the trouble to explain why one type of import affects the forex market more than another.
Economic analysts say expectations that foreign exchange can be 'saved' through hedging is based on a terrible mis-understanding of how monetary systems work in practice.
As long as imported products are market-priced and economic players pay the cost, and that money is used to buy foreign exchange - there is no pressure on the foreign exchange market.
This is because people and businesses have to give up some other spending in order to buy oil, bringing equilibrium to the monetary system, balancing demand pressure and keeping inflation in check.
This phenomenon, known as Ricardian equivalence is named after David Ricardo, one of the world's greatest classical economists. He lived 200 years ago in Britain.
Unless new money is printed by a central bank, through the acquisition of treasury bills or through its discount window or open market operations, people inside a country will only get money from exports or foreign remittances or capital inflows to initiate an import transaction.
Therefore imports are neutral on exchange rates when a monetary authority maintains a peg or fixed rate with a foreign currency by intervening in the forex market.
Inflation and exchange troubles are monetary phenomena created by final accommodation of transactions by a central bank.
External Anchor
Foreign exchange reserves of the central bank are only needed to cover the domestic money supply as a tool to match money supply with economic activity and keep inflation stable and in line with an 'anchor' currency.
Such a monetary tool is known as a peg or an external anchor.
Sri Lanka - and some 'third world' countries that run into frequent balance of payments troubles - maintains a peg with the US dollar as the anchor currency, instead of a floating exchange rate, partly due to its history of having a currency board or hard peg in colonial times.
If Sri Lanka did not have a monetary authority which created rupees in exchange for dollars, the entire country would have operated in dollars or other foreign currency.
Such an economy is known as a dollarized economy.
Exchange rate problems and balance of payments crises do not occur in such a situation.
Until 1950 Sri Lanka had a currency board, where local money was created in exact proportion to foreign exchange flows. Such an arrangement is also called a hard peg, where money supply expands and contracts exactly in step with foreign reserves.
Exchange rate problems also do not occur in such a situation.
Problems with the exchange rate and high inflation cropped up after a central bank with money printing powers was created by then finance minister J R Jayewardene in 1950.
A central bank which can print money in excess of net foreign exchange flows de-stabilizes its dollar peg, and such arrangements are called 'soft' pegs because they are prone to currency crises and high inflation.
Analysts point out that Sri Lanka went into a 'closed economy' through import and exchange controls after independence due to central bank money printing and that ordinary people were ignorant about how monetary systems worked.
This reversed the island's 'open economy' maintained for thousands of years by ancient kings of the island and the colonial period, until the economy was again 'opened' in 1977.
Soft Pegs
After the East Asian currency crises, soft pegs have been going out of fashion as more countries, either floated, went into monetary unions or dollarized. The International Monetary Fund which earned money from countries that had soft-peg troubles, lost business.
Exchange rate problems and even inflation can result when imported goods are subsidized by the government and the expense is 'monetized' or 'accommodated' by the central bank with printed money.
If a country has a floating exchange rate system, the exchange rate will simply fall when money is printed for oil or for any other government expense.
But when the central bank tries to maintain a peg and 'accommodate' dollar outflows by selling foreign exchange, and make up liquidity shortfalls in the domestic market by printing new money, the country will lose reserves.
Analysts say even now, with a hedge that has gone against it and the CPC has to pay 27 million dollars a month to foreign banks, it could still avoid pressure on the exchange rate by collecting money from the people and selling at a cost plus price.
Cost-based pricing maintains the macro-economic balance.
But if such dollars are bought from the central bank and the central bank prints money to make up for the shortfall in domestic money, Sri Lanka would continue to lose reserves.
Such a process, which started in mid-September, is known as sterilized intervention.
Over the past two months the central bank has lost more than 800 million dollars in reserves.
In late October foreign reserves were about 2.6 billion according to official data.
The central bank's Treasury bill stock is about 90 billion rupees now.
Timing Difference
But CPC also has other problems.
It now has to pay for loans taken earlier, especially from Iran, creating a mis-match in foreign exchange flows and the real economy initially, as the payments kick-in and the economy adjusts to a new equilibrium.
"The problem today is that we are paying bills that we bought six months ago," says de Mel.
"We have six months credit. We are paying high priced bills now and we reduced the price. So our revenue is coming down. We are paying higher prices."
Analysts say when a large dollar payment is financed through credit, which is then accommodated by the central bank either through its reverse repo window or through sterilized intervention of foreign exchange markets, the currency can be hit.
Such actions, analysts say, prevents the economy from facing up to the new reality and reaching equilibrium.
CPC's Iran liabilities are about 1.
1 billion dollars. De Mel also points out that for every dollar it 'loses' through the hedges, it 'gains' two when oil prices fall.
The IMF has advised the central bank to abandon a dollar peg if it wants to conserve reserves and not hurt domestic industry by 'over-valuing' the rupee.
Analysts have pointed out that the fundamental problem in Sri Lanka is the lack of a price formula which passes costs through the economy quickly and maintains economic equilibrium and keeps inflation low.
Politicians forced CPC to abandon a price formula in 2004, when economic policy reversed, driving the country into high double digit inflation. De Mel tried to revive an improved formula but was thwarted by politicians.
"All the formulas are good. But when people have to pay 150 rupees on a litre of diesel are they willing to pay that?
" asks de Mel.
"They are saying we elected a government not to increase the thing, they want subsidies. At the end of the day the government is compelled to give."