Greece Bonds: The reality

Friday, 4 November 2016 00:01 -     - {{hitsCtrl.values.hits}}


By Ajith Nivard Cabraal

In terms of Section 66 (1) of the Monetary Law Act, the Monetary Board is responsible for the management of the international reserves. In keeping with such authority and responsibility, the Monetary Board has approved Foreign Exchange Reserve Management Guidelines to empower and guide the officials of the Central Bank of Sri Lanka (CBSL) to manage the international reserves.

The decision making structure and process is described in the Guidelines which set out, inter alia, that the Governor has been delegated the authority by the Monetary Board to define and set the overall parameters for reserve management operations and the control of risks including the preferred trade-off between different risks faced and the Bank’s tolerance for loss in any given year. The Guidelines also require the performance of the portfolio to be reported to the Monetary Board on a quarterly basis or as and when deemed necessary. 

Further, the Guidelines provide for a Foreign Reserve Management Committee (FRMC) which is responsible for making policy recommendations to the Deputy Governor and the Governor on matters concerning the management of the foreign reserves and making decisions pertaining to operational aspects of foreign reserve management.

As a policy, the CBSL manages the foreign reserves in order to safeguard and enhance the value of its overall reserves as well as generate a reasonable income from its investments. Such management of the investments of the Reserves are carried out on a “pool” basis, which is the manner in which reserves are managed all over the world.

The track record of the investment activities of the Central Bank over the past 15 years is set out in the Table below. From such Table, it would be observed that the returns generated by the reserve management activities in the two years (2010 and 2011), had been well above the benchmark average US Fed Fund rate, and had yielded substantial profits of $ 341 million in 2010 and $ 430 million in 2011. The profit in 2011 has been arrived at, after making provision for all losses, which clearly shows that reserve management in 2011 had been highly successful in enhancing the value of the total portfolio, whilst also providing for the losses that had occurred in the highly challenging and volatile global environment.

In April 2011, when the CBSL purchased Greece Government Bonds, Greece’s Credit Rating by Fitch Rating Agency was BB+, which is three rating notches higher than Sri Lanka’s present credit rating of B+ (Negative). Thereafter, on 20th May 2011, Fitch downgraded Greece to B+ (Negative), which is the same rating as that of Sri Lanka at present. About seven weeks later, on 13 July 2011, Fitch downgraded Greece further to CCC when Greece was on the verge of default. 

Therefore, if it is now contended (in hindsight, of course) that Greece Government Bonds were not a viable option to invest in April 2011, it logically follows that Sri Lankan Government Bonds, at the present time, will be a worse investment option, as per the International Rating Agencies’ ratings. If a contention is made by a person in authority to that effect, it will be noted that such assertion could also place the Sri Lankan Government’s current outstanding debt (Government debt as at 30/06/16 was Rs. 9,062.2 billion as per Central Bank data) in a highly vulnerable position, as well.  

After the matter regarding the investment in Greece Bonds by the CBSL was raised at the Committee on Public Enterprise (COPE), the circumstances surrounding the investment were examined in depth by the Auditor General (AG). Thereafter, the AG confirmed that no irregularity had occurred and gave a report on 11 October 2012 to the Chairman of COPE, while also acknowledging that the CBSL had made a substantial profit in that year. 

After such report, COPE acknowledged that, although a loss had occurred, no wrong or illegal activity had taken place. It was also noted that the required procedures were followed by the CBSL and that proper disclosures and reporting requirements were adhered to. Accordingly, the final COPE report on the subject did not refer to the investment in the Greece Bonds, and no further follow up action was recommended by COPE. 

In the meantime, in 2012, a Fundamental Rights Case No: 457/2012 in relation to the Greece Bonds investment was also filed against the Monetary Board by Sujeewa Senasinghe, MP. It was argued by Upul Jayasuriya, PC. The Attorney General appeared for the Monetary Board. After hearing the FR case for nearly 2 years, “leave to proceed” was refused by a three-Judge Bench of the Supreme Court comprising Justice K. Sripavan, (now Chief Justice), Justice R. Marasinghe and Justice S. De Abrew with the order that, 

“Considering the totality of the circumstances, it is neither possible nor desirable to hold that the Members of the Monetary Board in taking a decision to invest in Greece Bonds, have acted arbitrarily, unreasonably and in a fraudulent manner.” 

(See the Supreme Court Judgement dated 18.09.2014 in the website of the Supreme Court). 

In this connection, a few significant extracts from the Supreme Court Judgement may be relevant: 

“The Auditor General in his letter dated 11th October 2012 addressed to Hon. D.E.W Gunasekara, Chairman on Public Enterprises (with a copy to the Governor, Central Bank) has stated though the Central Bank had incurred a loss from the investment in Greece Government Bonds, it has earned a total net profit of US$ 430.2 million on International Reserve Management during the year 2011….” 

“The investment in Greece Bonds and its trade forms part of the risk management strategy. If all investments are maintained as risk free investments the return would be negligible. The Central Bank therefore has to select a mix of low risk and risk bearing investments expecting a reasonably high return.” 

“The decision to invest in such Bonds was based on the trade-off between different risks faced and the Central Bank’s tolerance for higher risk on a very small part of its portfolio (only 0.6% of its portfolio was invested in Greece Bonds). Investing in high yielding sovereign paper is an integral part of fund management of many funds in the world and the Central Bank too had followed a similar practice in investing a tolerable proportion of its resources (0.6%) in Greece Government Bonds. When the Euro Zone took a turn for the worse several weeks after the investments were made, in mid July 2011, the Central Bank sold a part of Greece Bonds at a loss of US$ 6.6 Million. This measure was taken to mitigate the risk of the Greece investment losing further value due to subsequent development in the Euro Zone. Such loss has been taken into consideration in computing the profit/gains for the year 2011 amounting to US$ 430.2 Million.”

Internationally, the (hypothetical) benchmark safest investment is considered to be in US Government Treasuries. On that basis, a totally risk averse Investment Fund could decide to place its entire funds in US Treasuries only, and thereby (theoretically) suffer no loss. 

If the CBSL too had followed that total risk-averse path, (as also referred to in the Supreme Court judgement), and invested the entirety of its average reserves of around $ 6,500 million in two-year US Government bonds in the year 2011, the total return that the reserves could have earned would have been a mere $ 16.2 million only. As against such a return, the CBSL has been able to generate an income of $ 430.2 million through its investment strategies, which then works out to an additional $ 414 million or 26 times the return that would have been the yield on hypothetically “no risk” instruments only. 

It must also be mentioned that, as per CBSL financial statements, CBSL made its highest-ever average return of 6.6% on its reserve, and its highest-ever reserve management profit of $ 430.2 million, in 2011 (see table). In comparison, in the year 2015, after managing a foreign reserve of a value similar to that of 2011, the CBSL made a profit of $ 111 million only. In that context, if the CBSL administration in 2011 is blamed by some persons for the particular “losses” in the investment in Greece Bonds even while making an overall profit of $ 430.2 million in 2011, such persons will have to blame the CBSL administration in 2015 a lot more for being able to generate a profit of only $ 111 million in 2015. 

(The writer is a former Governor of the Central Bank of Sri Lanka.)