The issue of continual losses and

depleted capital: Central Bank still

misses the main point

Monday, 25 May 2015

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 doesnt like the way

his father keeps accounts and more specifically the way he calculates his profits. The point of
contention is that his father doesnt 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: Thats 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.
Dont 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 Banks 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--thenation-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-makingCentral-Bank-puts-nation-on-red-alert ) and the Article 2:
http://www.ft.lk/article/421599/A-Central-Bank-missing-the-mainpoint-puts-the-nation-on-%E2%80%98extra%E2%80%99-redalert ) one would instantaneously recall the wise counsel given by
the father to the son.
What it says is dont 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 banks inefficiency but due to the switch-over to
IFRS as its accounting template. This is the sons 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-bankbalance-sheet-losses-by-barry-eichengreen-and-beatrice-weder-dimauro-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 Banks 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 banks 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%99smandate-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.
\
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 Banks response under reference shows that the banks staff has not done justice to
Governors 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. Exters language is clear
enough for anyone to understand the true meaning of his objective.
Net foreign asset cover of Central Banks 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 Banks policy to be appraised not by outlay or output but by impact
The Central Banks 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 Banks response says that this writer has grossly misrepresented the Anil PereraDeborah 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 banks 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 waw1949@gmail.com )