Central Bank capital depletion is also a landmine under PM’s feet
Prime Minister Ranil Wickremesinghe, supported by Senior Minister Sarath Amunugama, castigated SriLankan Airlines in a recent press briefing. He said that the National Carrier which had made losses continuously for the last seven years accumulating in the process mounting debts now fixed at $ 3.2 billion was a ‘landmine’ planted on the people of the country.
Senior Minister Amunugama would not have been amused by PM’s equating the present plight of the National Carrier to a landmine because he as the Minister of Finance in 2004 was bold enough to name four loss-making State-Owned Enterprises as ‘monsters’ swallowing the nation’s limited resources. He was frank and realistic in his assertion but could not cage in the monsters due to his losing the job set himself on the job.
Perhaps both the Prime Minister and the Senior Minister would not have known at the time they appeared before the press that the nation’s Central Bank, making losses continuously for three years in succession amounting to a total of Rs. 88 billion and consequently depleting its capital base by Rs. 128 billion, is another landmine that could explode at any time under their feet. Worse, the Monetary Board which had been responsible for those losses had taken a very light-hearted attitude toward them like the management of the national carrier. The Board had argued earlier responding to this writer that losses at the Central Bank were not a problem because the Government at any time could recoup those losses.
Making profit transfers to the Government when the Central Bank had made losses
This writer, in public interest, raised the red flag one year ago in four previous articles in this series about the danger of a continuously loss-making central bank. In the first article, he questioned the governance of the Monetary Board – the owner of the Central Bank – when it made a profit transfer of Rs. 28 billion to the Government, while incurring a loss of Rs 39 billion in its comprehensive operations in 2013.
In accounting terminology, comprehensive operations cover both the factors which are within the control of a business called ordinary operations and all other factors which are outside its control. Hence, the impact on a business is to be reckoned by gauging the outcome of the comprehensive operations.
The loss in 2013 was followed by a comprehensive loss of Rs. 22 billion in 2014, but the accounts of the bank for 2014 showed that the Monetary Board had made an interim profit transfer of Rs. 8.5 billion to the Government out of these losses. An institution making losses can pay dividends to shareholders only by running down its capital and that was exactly what the Monetary Board had done in the two years concerned. Thus, the Central Bank’s capital funds which stood at Rs. 182 billion as at the beginning of 2013 was reduced by the Monetary Board to Rs. 81 billion by the end of 2014.
Monetary Board justifying the capital depletion
In the second article, this writer questioned the prudential wisdom of the Monetary Board in allowing the capital of the Bank to be depleted in the above manner. The implication was that it had reduced the cover of capital which a previous Board had decided to maintain, as an extra safety measure, in respect of its domestically created assets at 100% to a critically low level of 25% in 2014.
The Monetary Board apparently did not take this comment kindly and caused its operational arm – the Central Bank – to issue a statement disputing this writer. The Board had argued in its wisdom that there was nothing wrong in the Bank making losses because central banks are not supposed to make profits and it would be imprudent for a financial institution to have a capital base covering 100% of its domestic assets.
Monetary Board should not leave room for Parliamentarians to remove its independence
This writer in a third article in the series countered the Board’s arguments. The article under reference argued that though central banks are not supposed to make profits, they are not supposed to make continuous losses. That was because when a central bank becomes bankrupt with a negative networth – that is, when it does not have assets to cover its liabilities to outsiders – due to continued losses, the public as the owners of the central bank are required to recapitalise the bank at great costs.
The Monetary Board should not take this possibility lightly because, when the recapitalisation proposal is taken up at Parliament, the legislators would, for valid reasons, decide to take away the bank’s independence over managing its budget. The budget independence is essential, this writer argued, for a central bank to conduct monetary and financial sector policies independently of political interferences as required by the nation.
Further, the article argued that the central bank is not like any other financial institution as the Board had surmised, but the nation’s monetary authority with powers to create money just by making book entries. Hence, its ability to print money should be checked with appropriate capital funds and in that way, building a strong capital base in proportion to its created domestic assets was a sure way to prevent it from inflating the economy.
Monetary Board relying on academic work not relevant to Sri Lanka
The Monetary Board refused to accept its folly and caused the Central Bank to issue a further response countering the above arguments.
The Board had this time sought to substantiate its stand that there was no risk in the central bank making losses and allowing its networth to be depleted by quoting some academic work done elsewhere. These academics had argued that a bankrupt central bank could always be recapitalised by its owner, the government, and therefore, having a negative networth for a central bank was not a problem. It is true that a government with a sufficient budget surplus could find money to recapitalise a bankrupt central bank without making sacrifices elsewhere.
But this writer pointed out in a subsequent article that it was dangerous to rely on such wisdom and allow the capital to be depleted because Sri Lanka Government did not have free money to be wasted on a bankrupt central bank. The state of public finances in Sri Lanka is that the government at present finds it difficult even to repay public debt with its declining revenue base. Hence, the article opined that the Monetary Board should as a matter of urgency introduce a restructuring plan for the central bank to halt the depletion of its capital base and put a stop to the loss-making trend.
That was one year ago. But it appears that this piece of advice had not been heeded to by the Monetary Board as the financial outcome of the Bank for 2015 has now revealed.
Making losses for the third year in succession in 2015
The Annual Report of the Central Bank for 2015 which the Monetary Board has just released reports that the bank has continued to make losses for a third year as well. In 2015, its ordinary operations have resulted in a loss of Rs. 19.6 billion which has been topped up to Rs. 27.5 billion when its comprehensive operations are also reckoned. It has incurred a loss of Rs. 8.1 billion in its foreign exchange operations and made a marginal surplus of Rs. 403 million in its domestic operations. But with a staggering expenditure of Rs. 11.6 billion on account of its operations and the payment of withholding taxes to the Government amounting to Rs. 1.9 billion, the bank has ended up with a loss of Rs. 19.6 billion in 2015.
With another mounting expenditure component incurred by the Board to fill up the shortfall of Rs. 7.3 billion in the pension funds of the bank which the Board had failed to do in previous years, the total losses have increased to Rs. 27.5 billion. This last expenditure item, though had been paid out of capital, was a must which the Board had to incur to avoid its accounts being qualified by auditors. If that had happened, it would have brought a bigger calamity for the Board in particular and for the central bank in general in the eyes of outside stakeholders. The results of these losses have been to deplete the capital funds of the bank further from Rs. 82 billion as at the beginning of 2015 to Rs. 54 billion by the end of the year. The capital cover for the domestic assets of the bank has thus fallen from 25% at the beginning of 2015 to 18% as at the end of 2015.
Losses in terms of MLA are much bigger
The above losses have been calculated by following International Financial Reporting Standards known as IFRS. When the losses are translated into the way the losses should be calculated in terms of the Monetary Law Act, the picture is more alarming. In terms of these calculations, the losses have increased to Rs. 36 billion. This is a dangerous level to which the central bank has now been reduced by the Monetary Board knowingly or unknowingly. It is another monster baring its teeth at the Government and therefore, it cannot be ignored by Prime Minister Ranil Wickremesinghe who has already been worried about the landmine planted by the SriLankan Airlines under his feet.
Monetary Board is the risk manager of the Central Bank
It is difficult to comprehend why the Monetary Board, supposed to be made up of competent professionals, has been so negligent of its duty to maintain solvency in its financial operations. In terms of the Monetary Law Act, as this writer had pointed out in two previous articles (available here and here), it is the Monetary Board which is responsible for the successes or the failures of the Central Bank which does not have a legal status under the law. Hence, the Monetary Board cannot pass the accounts of the Central Bank without examining the emerging risks and submit the Annual Report of the Board to the Minister of Finance for tabling in Parliament without highlighting those risks.
In the risk analysis section of the accounts of the Central Bank for 2015, the Board has correctly admitted that it is responsible for identifying and controlling risks of the bank. However, in the risk analysis made by the Board, there is no mention about the impending risks out of the depleted capital base and the consequential reputation risk which the bank will have to face in the future.
Prudential diligence should be exercised on the finances of the Central Bank
The Board has to exercise prudential diligence when it manages its finances and transfers profits to the Government. It appears that on both counts, the Board has failed the nation. It has allowed the Bank to incur losses continuously for three successive years; it has also made profit transfers to the government when it had in fact made losses. Quite contrary to what the Board has done, prudential diligence requires it 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 for a valid reason. That is, as John Exter, the architect of the Central Bank, had 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 by allowing the Government to spend the profits so transferred. A profit transfer through such a mechanism would jeopardise the Board’s 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 accelerate such depletion by transferring profits to the Government.
Governor A.S. Jayawardena’s wisdom being ignored by the subsequent boards
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, 41% in 2013, 25% in 2014 and now 18% in 2015. The ratio is, therefore, just above the minimum statutory level and if it falls below the statutory requirement of 15%, the Central Bank is technically bankrupt needing capital infusion by the Government.
Monetary Board owes an explanation to the people
It is interesting to learn whether the Monetary Board, while submitting the Annual Report to the President, the Prime Minister and the Minister of Finance, apprised them of this oncoming danger. It will not be a pleasant experience for the Government to learn of it either from the media or from the opposition Parliamentarians. The press release issued by the Board on the occasion of the release of the Annual Report for 2015 does not say a word about the losses made by the Central Bank and its implications to the public.
Hence, the Monetary Board owes an explanation to the public what action it would take to reverse the trend and the time frame within which such reversal would be attained.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at firstname.lastname@example.org)