The article in the Daily FT on 17 April titled ‘Treasury Bond fiasco leads to Rs. 42.5 b bleed claim analysts’ conveys the claims of analysts that as a consequence of the events of 27 February, the cost of borrowing for the Government has increased by Rs. 42.5 billion.
I shall now argue that not only is the methodology used to obtain this number incorrect (with the actual number being significantly less), but more fundamentally, the assertion that it is due to the Bond scandal is without basis.
Fundamentals of the Bond market
Before we address the claims at hand, it is instructive to recall the basic mechanism by which interest rates are formed in the Government Bond market. Typically governments announce an overall borrowing requirement and ask the Treasury (and in Sri Lanka, the Central Bank as its agent) to finance this by issuing Bonds of various maturities.
A Bond with a longer maturity requires the Government to repay the Bond over a longer period (or is due further in the future). For the sake of compactness I will focus now on Bonds for which the only payment due is at the terminal date (or maturity).
These are called zero-coupon Bonds, as they require the borrower not to pay any interest before the terminal date. (A Bond that requires the payment of coupons throughout the life of the Bond has a slightly more complicated method to calculate its value, but the approach fundamentally is the same.)
The role of the Treasury, in Sri Lanka together with the Central Bank, is to finance the borrowing need at the lowest possible cost and they can achieve this by issuing Bonds of various maturities.
The Government announces a borrowing requirement for each type of Bond it is to issue (the type is typically defined by the maturity). The market then bids for each of these Bonds by privately stating the interest rate they would like to receive and the amount they are able to lend.
The Government then collects the bids from the market and accepts the bids that fulfil their borrowing requirement at the lowest cost. Typically a single Bond has a face-value, which is the amount that the holder of a Bond is entitled to at the maturity date of the Bond.
For argument’s sake, let us say that the face-value of a Bond is Rs. 1 million. When the market bids for Bonds, they effectively state how much they are willing to pay today to receive Rs. 1 million at maturity.
The per cent difference between these two numbers gives the yield to maturity or interest rate that someone that holds the Bond would obtain, on an annual basis.
For example, a two-year one million rupee face-value Bond may be purchased by the market for 900,000 rupees. The effective annualised interest rate is given by 1,000,000/9,000,000=(1+i)2 or i=5.41%.
However in a year’s time, the holder of the Bond may decide to sell the Bond in the market to someone else. At this point, the price of the Bond could either increase or decrease according to market conditions. The interest rate on the Bond at that date would then be the interest rate on a one-year. This is why holding a two-year Bond for one year is more risky than purchasing a one-year Bond directly.
Typically, this is why Bonds of longer maturities tend to have higher interest rates than Bonds of shorter maturities. For example, if the Government is unable to repay the short-term maturity Bonds when they are due, they will then need to issue new Bonds at an interest rate that may be substantially higher than current long-term interest rates.
Let us now turn to the claims in the FT article about the cost of the Bond scandal.
The article asserts that the cost to the tax-payer today of the rise in interest rates is Rs. 42.5 billion. This number is obtained by calculating the cost of new Bond issues, since the Bond scandal occurred, using current interest rates and determining the difference with the cost using interest rates before the Bond scandal.
This number is determined at an annual basis and the total incremental cost for each Bond issue is determined by multiplying this difference by the tenure of the Bond.
For example, the Government issued a Rs. 10,058 million 30-year Bond on 27 February at an annualised interest rate of 11.73%. Prior to the Bond scandal, the interest rate on a 30-year Bond was 8.85%.
The incremental annual cost was calculated as 10,058×(.1173-.0885)=290million. The analysts then proceeded to multiply this amount by the tenure of the Bond to obtain 290×30=8,700 million. However this implicitly means that the value of 290 million rupees on 27 February 2016 (in one year) is the same as the value of 290 million rupees on 27 February 2045. They are not.
The value today of an additional 290 million rupee payment in 30 years is calculated by determining how much additional money the Government should have today in order to meet the additional payment in 30 years. Put another way, one can ask the question, how much would a market participant be willing to pay now for 290 million rupees in 30 years? To answer that question we need to match payment streams.
If one was to spend 10.4065 million rupees today buying a 30 year Bond today, at 11.73% interest rate, the value of this Bond in 30 years, is 10.4065×(1.1173)30=290 million rupees.
As this is the cost of securing a payment of 290 million rupees in 30 years, then 10.4065 million is the value today of this interest payment. For each of the 30 years we need to similarly discount the payment of 290 million rupees to obtain the total additional cost of borrowing for the 30-year Bond.
Note that we must use the current interest rates to discount. In this way, we can calculate the true incremental cost of borrowing for the Government and it comes to 25.9 billion rupees: a large number, but substantially different from the asserted 42.5 billion.
The table gives the methodology used in the calculation of this number. As you will see, to be fair to the authors of the FT article, I followed their numbers and methodology as closely as possible.
Cause and effect
The article implies that the higher interest rates since 27 February are due to the Bond scandal. This causal claim is never explained or justified. It is true that interest rates did rise, but there is no basis to assert that it was caused by the Bond scandal.
The allegation being made in the Bond scandal is that certain traders obtained higher interest rates for their Bond purchases. However the claim that this led to a rise in all interest rates misrepresents the way the Bond market works.
In reality, each Bond auction is conducted separately. One explanation for the overall higher interest rates since 27 February is that traders are continuing to benefit from private information. This is because there is one privileged individual, or all market participants have coalesced to raise interest rates.
There is no evidence that I am aware of that can support this and, given that the Central Bank Governor has not been involved with the Central Bank since the scandal broke, and the heightened scrutiny under which Treasury Bond auctions are conducted, this argument is hard to believe.
In short, there is no basis to argue that the Bond scandal raised all interest rates in the same way.
A more plausible explanation
A more reasonable explanation for rising interest rates, immediately following the Bond scandal, lies with the information that was revealed through the incident. The information that is alleged to have been inappropriately obtained is the true borrowing requirement for the Government, which was substantially higher than the publicly-stated amount.
When the details of the incident became public, it also became public information that the borrowing requirement of the new Government is higher than anticipated before. A higher borrowing requirement translates to the Government needing to issue or sell more Bonds, and just as when the supply of fish increases, the price of fish falls, when the Government has to issue more Bonds, the price of Bonds falls. A fall in the price of Bonds translates to a higher interest cost for the Government.
The natural question then is why the Government needed to borrow in greater amounts from the domestic Bond market, and more so than the previous Government. To a great extent, this can be explained by the decline in foreign currency debt issued by the Government or by Sri Lankan banking system.
A reduction in foreign loans, and an unchanged total amount of domestic savings, results in a decline in the total amount of available savings in the country. In other words, the demand for Bonds declined. A decline in the demand for Bonds, and an increase in the supply of Bonds then, like the market for fish, results in the price for Bonds declining and interest rates for all Bonds to increase.
The true increased cost of borrowing
If the increase in the interest rate is because of a decline in foreign borrowing, then one may ask why the Government is not inclined to borrow from abroad like the previous Government. An increasing reliance on foreign debt has additional risks that are not completely captured in the interest rate.
Firstly, the interest rate on foreign debt depends, to a large extent, on world macroeconomic conditions. Given the uncertain policy environment in the US and Europe, raising debt from foreign markets means that future interest rates may fluctuate and unfavourably.
Secondly, Sri Lanka has increasingly relied on shorter maturity loans from abroad. This entails not only a more severe risk that interest rates will fluctuate when these loans are ‘rolled over’ or repaid through additional borrowing, but also that foreign investors may not lend at all if there is increased uncertainty in Sri Lanka, Asia or emerging markets in general.
The Asian financial crisis of 1997, and subsequent political and economic upheavals in South-East Asia, provided a stern warning for countries attempting to borrow from abroad at short maturities. In this light, the calculated higher rupee borrowing cost of the government needs to be reduced by the potential risks of foreign currency borrowing.
One may argue that the Central Bank ought to reduce interest rates, thereby reducing the cost of borrowing for the Government. This argument does not consider the different responsibilities of the Central Bank from the Government and why the Central Bank needs to make policy decisions independently from the Government.
The responsibility of the Central Bank is to maintain price-stability (low inflation) and maintain economic growth. It can achieve this by setting one interest rate. This is the interest rate at which the Central Bank is willing to lend to the banking system for one night. It is able to achieve this target interest rate by altering the quantity of money in the economy throughout the day (open market operations).
Conventional wisdom is that raising this policy interest rate, raises most if not all interest rates in the economy (including the ones that affect government borrowing), lowers the demand for credit (as it is more expensive to borrow), reduces the supply of money in the economy and ultimately lowers the rate of inflation. However, raising interest rates also increases the cost of borrowing and investment, and negatively affects growth.
On the other hand, lowering interest rates stimulates investment and growth at the cost of higher inflation. The Central Bank is therefore tasked to balance these two competing concerns in setting the policy rate.
It is true that lowering the policy rate will reduce the cost of borrowing for the Government, however if this were done at the cost of unacceptably higher inflation, then the Central Bank would have failed its mandate. As such, the Central Bank should, and by enlarge has, make decisions on the policy interest rate independent of the concerns of the Government.
Although the innocence of the main players in the Bond scandal is far from resolved, the economic impact of this event to the Government and the economy at large is contained to the particular Bond issue in question.
The claim that the generalised rise in Government Bond interest rates is due to the Bond scandal is difficult to reconcile with the facts and practices that have emerged since 27 February.
The increase in subsequent interest rates is most likely due to broader macroeconomic conditions and policy decisions of the Government. Although the appropriateness of these policies may be in question, the higher cost of borrowing cannot be attributed to the Bond scandal.
(Dr. Mahatelge Udara Peiris is an academic macroeconomist and currently an Assistant Professor of Finance at the National Research University Higher School of Economics in Moscow. He was formerly a Teaching Fellow at the University of Warwick and a Lecturer in Economics at Corpus Christi College and University College, University of Oxford. He completed his MSc and PhD in Financial Economics at the University of Oxford as a Clarendon Scholar.)