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Total losses are much more than the ordinary losses
The ordinary operations are the ones which the Central Bank has to undertake in order to accomplish its main mission in society. That includes expenditure incurred to realise the two co-objectives of attaining economic and price stability and financial system stability and numerous services rendered for the government such as the management of the country’s foreign exchange reserves. 
Comprehensive operations add up to these ordinary operations some extraordinary expenses like the replenishment of the staff retirement schemes and book losses or profits recorded when reassessing the value of property and securities available for sale. These are also legitimate expenses of the Bank. Thus, for practical purposes, it is the comprehensive loss which should be taken into account when appraising the Central Bank’s operations.
Losses have come exclusively from bank’s foreign exchange operations
The loss in 2013 has exclusively come from the bank’s foreign exchange operations since its domestic operations have still generated a net income of Rs. 14.5 billion. In the foreign exchange operations, the gross losses have been a thumping Rs. 69 billion made up of as follows: losses on account of assets whose prices have fallen in the market leading to a decline in the book value by Rs. 28 billion; revaluation of foreign exchange balances by Rs. 27 billion and the decline in the book value of assets which are available for sale by Rs. 14 billion.
In the second item, losses are incurred when the rupee appreciates against the liquid foreign currencies held by the bank and/or prices of the bank’s gold reserves have declined in the market. The rupee has depreciated against the US Dollar during the year by .Rs 3.59 and against the Euro by Rs. 7.50, the two main currencies in which the liquid foreign exchange balances are held, indicating a revaluation profit on that count. Hence, the loss reported in the financial statements is attributable to the substantial fall in the gold prices in the market during the year.
The Central Bank had purchased its gold at prices below $ 1,000 per fine ounce over the years and hence, a price of around $ 1,200 per fine ounce as at the end of 2013 should not result in a revaluation loss. The bank has not disclosed any information on this matter and therefore, an analyst has to speculate what the bank would have done from the available information in its Annual Report for 2013 and elsewhere.
Smart accounting has been defeated by the market
According to the World Gold Council that also reports on the gold balances held by central banks as reserves, Sri Lanka had sold 10.4 tons of gold out of its reserves during 2012 as a part of its trading activity. The presumption is that the Central Bank had capitalised on the high price of gold in the open market by selling its gold reserves to show a high profit in the year under reference. This is evident from the financial statements of the Bank for 2012 where it had recorded a profit of Rs. 50 billion out of its foreign exchange operations.
However, the World Gold Council data also show that the Central Bank had repurchased gold amounting to 13.8 tons in that year at the prevailing high prices and out of this amount, 9.8 tons had been bought in December alone. The strategy had been to show high profits in 2012 and at the same time to show that the bank’s gold reserves had not been depleted. But this strategy had backfired in 2013 when the open market price of gold had fallen from around $ 1,600 per fine ounce as at the end of 2012 to around $ 1,200 as at the end of 2013.
Hence, the revaluation of the Central Bank’s gold reserve of 22.95 tons as at the end of 2013 at the new lower prices should necessarily result in a loss. It appears that the smart accounting done in 2012 has been defeated by changes in the market prices in 2013. The quality of risk management at the Central Bank, it seems, had been far from the desired.
Central banks should not pursue profit targets from domestic operations
Central banks are not supposed to make profits through their domestic operations but allow profits to be generated in ordinary business activities. The logic behind this principle was discussed in detail by this writer in a previous article in this series under the title ‘Should central banks make profits?’ (available at: http://www.ft.lk/2013/09/23/should-central-banks-make-profits/).
The underlying reasoning is that central banks can acquire assets such as government’s Treasury bills just by making a book entry in which it will create a liability in the form of new currency issue, also known as money printing, simultaneously. No one else in an economy has this power. When money is issued over and above the required level by the economy, it overheats the system generating inflationary pressures. Thus, central bank profits are proportionate to the level of inflation it has created in the economy. In other words, it means that higher the inflation, higher the profits and vice versa.
Because of this reason, central banks are not supposed to go behind a profit target as in the case of a normal business enterprise. Hence, profit making by a central bank through its domestic operations should be done cautiously.
Central bank foreign exchange operations should generate profits at acceptable risks
However, this cautious approach is not applicable to a bank’s management of a country’s foreign exchange reserves. Profits from such operations are not made by printing new money but by prudential management of the foreign exchange reserves. Hence, the nation which has entrusted this task to a central bank expects the bank to make moderate profits out of foreign exchange reserve management by taking acceptable levels of risk. This is because if a central bank loses foreign reserves due its risky investment practices, it is the nation which loses such wealth and not the central bank.
Such moderate profits it may have earned become inflationary only when a central bank transfers them to the government by way of a profit transfer. That is because when the government uses such profit transfers to make domestic payments, money in the hands of the public will increase creating an additional demand for goods and services. If the domestic supply does not go up in a compensating manner, the increase in domestic demand is to create inflationary pressures. But, if a central bank keeps such profits as reserves within the bank, they do not lead to inflation in the economy.
Profits should be used to strengthen capital funds of a central bank
Thus, while the profits that arise from the domestic operations of a central bank are a consequence of its business, profits earned from foreign exchange operations should be a target pursued by it. Profits in either type of business, when kept inside a central bank without transferring to the government or paying out to any outside parties, will increase its capital funds. It therefore strengthens a central bank’s independence making it less dependent on the government for capital funds in the event of a severe erosion of its capital base.
To acquire this capability, a central bank should not necessarily make losses. A continuously loss making central bank will have its capital base fully eroded making it insolvent eventually. An insolvent central bank will be closed down as was the case with the Central Bank of the Philippines in early 1990s. Hence, losses are a taboo for a central bank which aspires to remain solvent.
Government has no first right to central bank profits
In the recent two decades or so, the Government of Sri Lanka had placed a greater reliance on the annual profit transfer of the Central Bank to finance its operations. However, in terms of the Monetary Law Act, the government does not have the first right to the Central Bank’s profits. The Act has laid down a special procedure for the bank to appropriate its profits.
Accordingly, after the net profits have been ascertained, the bank should use them to eliminate any past extraordinary expenditure that had been capitalised by the bank without charging to the profit and loss account in that year. If any profit is remaining after eliminating such capitalised expenditure, it should be used to build up internal reserves until such time such reserves are equal to at least 15% of the domestic assets of the bank.
A profit transfer to the government can be made by the Central Bank only if any remaining profits are available. Thus, the top priority in appropriating Central Bank’s profits is to build a strong bank and not the transfer to the government. It then follows that, if the Central Bank has made losses, there is no question of making a profit transfer to the government at all.
If there are no profits, there are no profit transfers
There is one previous precedent on this count. In 2005, the Central Bank made a loss of Rs. 6.2 billion, mainly due to the losses arising from the revaluation of foreign exchange reserve of the bank at the prevailing exchange rate. The rupee had appreciated against the dollar by Rs. 2.49 in 2005 mainly in consequence of the massive inflow of funds to the country following the Asian tsunami of December 2004. This resulted in a revaluation loss of Rs. 13 billion which ultimately led to an overall loss of Rs. 6.2 billion.
The Government had anticipated a profit transfer of Rs. 2.5 billion from the Central Bank in its Budget for 2006, but the bank did not accede to that request in view of the losses it had incurred due to reasons beyond its control. In essence, if the Central Bank has made losses, there is no possibility for it to make a profit transfer to the government.
Profit transfer to Government in 2014 amid a loss in 2013
But this was not what the Central Bank had followed in 2014. The bank had made losses amounting to Rs. 39 billion in 2013 but it has made a substantial profit transfer to the Government in early 2014. While the Central Bank’s weekly economic statistics are silent on this profit transfer, it has been vaguely reported in the Fiscal Management Report 2015 that has presented the position of the Government’s budgetary operations in 2014.
The report has mentioned that one of the reasons for the poor performance of the non-tax revenue during 2014 has been the decline in the profit transfer of the Central Bank to the Government by 19.9% when compared with 2013 (p 35). Since the Central Bank’s profit transfer to the Government in 2013 has been Rs. 26.4 billion, a transfer of profits lower by 19.9% amounts to Rs. 21 billion. This amount has been paid by the Central Bank against an anticipated profit transfer of Rs. 23.5 billion in the Budget 2014.
The alarming erosion of the Central Bank’s capital base
The Central Bank has not made a public disclosure as to how it has made a profit transfer of Rs. 21 billion in early 2014, reported vaguely by the Ministry of Finance and Planning in its Fiscal Management Report 2015 to Parliament, when the bank has made a colossal loss of Rs. 39 billion in 2013.
Profit transfers, by definition, arise out of profits and not out of losses. Thus, if the loss incurred Central Bank has made it, it has been done by the Bank by using its reserves which it is not authorised to do in terms of the Monetary Law Act. It is therefore a violation of the law. Further, the depletion of reserves leads to an erosion of the capital base of the bank, driving it to a serious risk concerning its solvency.
The losses in 2013 alone had shrunk the capital base of the central bank by Rs. 67 billion from Rs. 182 billion at end 2012 to Rs. 114 billion at end 2013. Thus, the capital base of the Central Bank has fallen from 46% of domestic assets at end 2012 to 41% at end 2013. With a profit transfer out of reserves of the bank in 2014, the ratio is expected to fall further.
This trend records a significant decline in the ratio of 73% at end 2005 and an unacceptable reverse of the goal of the bank to reach 100% under its modernisation programme implemented during 2000-5. It is demonstrative of a serious dent in the governance practices in the Central Bank which is expected to set an example to other financial institutions in the country.
To rescue the Central Bank, go for a second modernisation program
The strength of any institution comes from the good governance practices it follows. The Central Bank had been a trendsetter and an example to others in the past. The objective of the Central Bank modernisation project was to further strengthen its position by improving governance, disclosure policy, management capacity and financial strength. What has happened in the recent past has been an erosion of all these good attributes. If the bank is to be rescued at this stage, it will necessarily have to go for a second modernisation program as a matter of top priority.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)
