The issue of continual losses and depleted capital: Central Bank still misses the main point

A parable from accounting teachers

Accounting teachers are used to relating a story to their students when they are introduced to the concept of profit in an organisation. The objective is to show them that ultimate profits of a business are not found in the profit and loss statements but somewhere else in the balance sheet. The story goes as follows:

 

Wisdom of ordinary businessmen: Profits are the increase in the net assets

There is this rural youth who migrates to the city with only the clothes on his back. But that is not much - a sarong, a shirt and a pair of slippers. Through sweat, labour and sheer hard work, he soon becomes a businessman of worth. 

He sends his son abroad - say to the US - for further studies and he returns to the country after getting  a degree in business management. From day one onwards, the son doesn’t like the way his father keeps accounts and more specifically the way he calculates his profits. The point of contention is that his father doesn’t follow an accounting standard or system. The son suggests to the father that they must have the most modern computer system to keep accounts so that they can easily calculate the profits which the business has so far earned. The father tells the son: “That’s not a big deal. I started the business just with a sarong, shirt and pair of slippers. Deduct the cost of those items from all the assets which we have now after taking out the borrowings we have made and the figure will tell you the amount of profits we have made.” 

 

Don’t blame accounting standards which are only a tool

What the father has referred to here is the increase in the net worth of the business represented by the increases in the capital funds. His lesson to the son is that the accounting standards or the profit and loss account are just ways to calculate the change in the net worth. 

Therefore, if one knows the net worth one should not worry about the accounting standards or the profit figure in the profit and loss account. If the net worth has increased, they have made profits to that extent. If the net worth has declined then they have made losses. It is as simple as that.

Central Bank’s capital funds are falling whether you go by IFRS or MLA

When one reads the latest response of the Central Bank (available here: http://www.ft.lk/article/423515/Central-Bank-responds-to-%E2%80%98A-Central-Bank-missing-the-main-point-puts--the-nation-on-%E2%80%98extra%E2%80%99-red-alert%E2%80%99) to the two articles of this writer on the issue of continual losses in the Central Bank and the consequential depletion of capital funds or the net-worth (available here: Article 1: http://www.ft.lk/article/417877/The-continually-loss-making-Central-Bank-puts-nation-on-red-alert ) and the Article 2: http://www.ft.lk/article/421599/A-Central-Bank-missing-the-main-point-puts-the-nation-on-%E2%80%98extra%E2%80%99-red-alert ) one would instantaneously recall the wise counsel given by the father to the son. 

What it says is don’t worry about whether you calculate your profits in accordance with the International Financial Reporting Standards, known as IFRS, or the system recommended by the Monetary Law Act or MLA. Just look at the movement of capital funds or the net worth to assess where the Central Bank is heading. Ignoring that the capital funds are falling which is the main point at issue, the Central Bank has been presenting lists of data which have calculated profits in terms of IFRS and MLA. 

Accounting students know that both are just techniques adopted to ascertain the capital funds of the bank accurately. Hence, as for the final results, both lead to the same outcome. 

 

Basic accounting knowledge a must

The Central Bank is the premier knowledge-based institution in the country staffed by technically qualified officers. Even the economists in the bank are required to know basic accounting if they are to be promoted to the next higher grade. Knowledge of accounting is necessary for the Central Bank officers to work in all the departments including its regional offices. 

A pure economist without accounting is likely to make wrong judgments when interpreting accounting statements. This is pretty much evident in the response which the Central Bank has issued in downplaying the depletion of the capital funds of the bank in the recent past. 

The bank has said that its capital was increased by the Monetary Board to Rs. 50 billion in 2014. This again displays the limited accounting knowledge in the bank because the capital was increased simply by transferring capital reserves to the paid up capital with no increase in the total capital funds. A Monetary Board taking pride in such a smart accounting measure is like a woman who transfers her jewellery from one box to another and announces that she has more jewellery in the new box.

Declining capital funds is a matter of grave concern

In the table presented by the Central Bank in its response, it has made an attempt to show that the Bank is still a profitable institution if one works out its profits in terms of the limited scope given in MLA. 

At the same time, it has presented the profits of the bank when calculated in terms of IFRS which has changed from profits in one year to losses in another year. Hence, what is being implied is that the loss position is not due to bank’s inefficiency but due to the switch-over to IFRS as its accounting template. This is the son’s perspective of profits in the story related above. For him, profits are necessarily those that arise in the profit and loss account and if there are profits recorded in that account, the business is essentially profitable. But the profit and loss account is useful but not conclusive in assessing the profitability of a business. For that, as also mentioned above, one should look at the movement of capital funds. The data reported by the bank show that capital funds have peaked to Rs. 182 billion in 2012. 

This writer argued in his first article that the bank had done this by practising smart accounting where it had sold its gold stock at high prices to show profits and bought back the same at high prices to show that foreign assets have not been impaired. 

However, in 2013, capital funds have declined to Rs. 115 billion and at end 2014, they have further declined to Rs. 82 billion. In terms of domestic assets, they have fallen from 63% in 2013 to 25% in 2014. Given the high interest out-payment of the bank to absorb the excess liquidity in the market and high administration expenditure that cannot be curtailed as well as the potential mark to market losses of its foreign assets, the best scenario which the bank could have will foretell that the depletion would further be accelerated in the current year.

Barry-Beatrice wisdom is good for a country with a financially strong Government

The Central Bank has justified this depletion on the ground of its attaining better macroeconomic results in the recent past. For the bank, the macroeconomic attainment just consists of two variables, namely inflation rate and real economic growth rate. 

Accordingly, the inflation rate which had peaked at 23% in 2008 has gradually fallen to 3.3% by 2014. The growth rate has averaged during this period at around 7% per annum. These two numbers have made the bank complacent about its achievement. Thus, it says that making losses does not matter since it has served the purpose of the Central Bank. 

It has relied on a column published by two academics who say that a Central Bank need not worry about capital depletion since it can operate with a negative net-worth for a significant period and if the need arises, the Government can capitalise on it (available at: http://www.project-syndicate.org/commentary/central-bank-balance-sheet-losses-by-barry-eichengreen-and-beatrice-weder-di-mauro-2015-02 ). 

It is dangerous to rely on such wisdom by Sri Lankan authorities since Sri Lanka Government, as this writer argued in his previous article, does not have such free money to be wasted on a bankrupt Central Bank. The Government cannot bridge its finances; it also has a dozen of loss making public enterprises involving some Rs. 300 billion if they are to be rescued. If the Central Bank is also added to this list, the Sri Lanka Government will certainly become bankrupt for lack of funds to recapitalise the ailing Central Bank. 

Hence, Barry-Beatrice wisdom is to work only in a country where the Government has enough space to increase taxes and recapitalise the Central Bank. In all other countries, it is wiser for the central bank to follow the rule of thumb that says that you cannot continue to survive if you make losses continually depleting your net-worth. This is the prudential diligence which the Central Bank is required to exercise as argued by this writer and grossly downplayed by the current Central Bank management. 

 

A cancer patient being happy because his cancer is still small

In the case of the Philippines where the Central Bank became bankrupt in 1993, fortunately, the US Treasury, Government of Japan and IMF came forward to rescue the country. Relying on such international intervention to bail out the Central Bank will have a lot of negative political ramifications for Sri Lanka. 

If the Central Bank’s net worth is negative and if it is tolerated according to Barry-Beatrice wisdom, Sri Lanka will lose international market access immediately without which it cannot bridge its domestic as well as foreign financing gaps. 

It is strange that the Central Bank of Sri Lanka argues that depleted capital funds are not a problem because it has pushed the inflation down to allow economy to grow at 7% per annum. To say that the current level of capital in the Central Bank which is depleting is not a problem is like saying that a cancer patient need not worry because his cancer is still not big enough to be worried about. 

 

Forgetting the statutory mandate by the Central Bank

There is another reason why the Central Bank should not be complacent about what it has achieved by incurring losses going by Barry-Beatrice wisdom. The mandate of the Central Bank is not just pushing down the consumer price index but attaining economic and price stability. Over the years it appears that the bank’s young Turks have forgotten its mandate and seem to be happy when the Consumer Price Index which can be manipulated shows a low increase. 

Such manipulations are done by governments by giving subsidies or cutting administered prices while running bigger deficits in their budgets. As this writer presented in a previous article in this series, (available at: http://www.ft.lk/article/51258/Central-Bank%E2%80%99s-mandate-is-to-attain-both-%E2%80%98economic%E2%80%99-and-%E2%80%98price%E2%80%99-stability ) the word ‘economic’ was added to ‘price stability’ when MLA was amended in 2002 to prevent this obvious misperception. 

 

The Central Bank cannot be happy by mere decline in the consumer price index 

Accordingly, the Central Bank cannot be happy about its attainment unless there is macroeconomic stability in the country. That involves the stability in the general price level supported by stability in the exchange rate. The facilitating elements for this achievement are a stable government budget and a comfortable external sector. 

The unstable macroeconomy in Sri Lanka is evident by the mounting pressure for the exchange rate to depreciate despite the reported decline in the manipulated Colombo Consumers’ Price Index and high growth rates. The Central Bank has been worsening the macroeconomic equilibrium by cutting interest rates, pumping money to the market through foreign borrowings and conducting a monetary policy supportive of a Government bent on spending more without resources. Hence, those outside the Central Bank cannot be prevented from viewing its losses as money spent without gaining value for same.

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Misreading John Exter

When Governor Arjuna Mahendran addressed the staff on assuming duties, he advised all Central Bank officers to read the Exter Report because it contained sound central banking principles (available at: https://www.youtube.com/watch?v=hf6uKcfhpuI ). 

The Central Bank’s response under reference shows that the bank’s staff has not done justice to Governor’s call when the response says that Exter did not suggest an anti-inflationary strategy when he stipulated that capital funds be built first before considering the transfer of profits to the government. Justifying the special procedure for treating central bank profits in Section 39, Exter says, “Central Bank profits deserve special attention because of the inflationary and deflationary effect which their payment or non-payment can have on an economy.” (page 22 of Exter Report). 

Then he gives a detailed explanation of how it happens and why he has recommended the special procedure. This has now become general central banking wisdom and all Central Bank legislations have introduced similar procedures to their statutes. Exter’s language is clear enough for anyone to understand the true meaning of his objective.

 

Net foreign asset cover of Central Bank’s sight liabilities not adequate

The Central Bank has taken pleasure in plotting the currency issue against its net foreign assets to show that its balance sheet is in a proper position. Such a plotting would have been relevant to a pure currency board and not a central bank which also holds deposits of commercial banks and government and government agencies as sight liabilities on its balance sheet. 

In terms of special accounting in a Central Bank, the currency issue and deposits are exchanged freely between the two types of liabilities. For instance, when the Central Bank receives currency, it reduces the currency issue but increases the deposit liabilities and vice versa. Hence, the appropriate comparison should be currency plus total deposits with net foreign assets and not mere currencies. This is because both have to be repaid by the Central Bank on sight and not on demand. As at the end of 2014, net foreign assets of the Central Bank had covered only a two third of its total sight liabilities. In a scenario where the net foreign assets of the bank are falling as is the case at present, this cover is to decline further. It therefore shows that additional capital cover is needed to protect the sight liabilities of the bank.

 

Central Bank’s policy to be appraised not by outlay or output but by impact

The Central Bank’s response has maintained that it had earned an acceptable reserve management yield in the past implying that it would not lead to losses in the future. This is a contentious argument since the future yield rates will depend not only on the interest rates but also on the volume of foreign exchange reserves available to the bank. 

As it is, the bank is being hit on both counts, with interest rates in Euro area falling to near zero level and its foreign reserves falling from $ 9 billion to $ 7 billion between August 2014 and April 2015. To work on the assumption that the past will be repeated in the future is not a proper risk management technique. 

It requires the bank to be ready for the worst scenario possible and take appropriate action to counter adverse developments. The bank has said that it has set up a new risk management and compliance department to upgrade its risk management. It is a promising development. Yet, the public policies are assessed today not on account of the money spent or the output produced but on account of the impact they have created. The bank has delivered the first two but the result of the last are yet to be learned.

 

Ignoring the strong message of PRW paper

The Central Bank’s response says that this writer has grossly misrepresented the Anil Perera-Deborah Raltson-Jayasinghe Wickramanayake paper abbreviated as PRW paper on the strength of the net-worth of a central bank and its policy independence. Once again the language used by PRW is clear enough for an ordinary reader to understand their message. PRW say in their abstract: “Our results have important implications for policy makers. Particularly, our results suggest that avoiding persistent losses and maintaining the health of the central bank balance sheet remain vital pre-conditions for desirable policy outcome of a central bank”  This desirable outcome is attaining economic and price stability in the case of the Central Bank of Sri Lanka. In the concluding part, PRW argue that “the robust relationship between CBFS (Central Bank Financial Strength or its net worth) and inflation suggests that central banks would need to avoid losses with a view to maintain their balance sheet strength and hence to support low inflation outcomes.” PRW say that any achievement of low inflation without a strong balance sheet will be temporary. Why? Because, according to PRW, their results “imply that the level of economic development and higher levels of central bank independence remain important determinants of inflation.” 

How a Central Bank would lose its independence when the government has to recapitalise it was clarified by this writer in the article under reference: You first lose budget independence and then the policy independence. A Central Bank which disregards this vital chain of events going by Barry-Beatrice type wisdom that has overlooked the political economy of developing countries certainly does not do any good for the nation which should be the bank’s real master.

This writer therefore reiterates that the Central Bank should necessarily go for a restructuring plan in order to avoid being a burden to the nation.

(W.A Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected] )