Perpetual and the problem of

unfettered capitalism
Tuesday, 18 October 2016
Questions about rampant capitalism are raised not just in Sri
Lanka but in all developed financial markets. Hence, calls for a
more subdued, socially conscious process reverberate here as
well, and these arguments are important.
Once we set the rules, the private sector steps in to maximise
profit acting within the neoliberal agenda. That is the system we
have created for ourselves, and our private sector is no exception.
But, like elsewhere, the nexus between the private sector and
Government is a complex one, and some believe it has gone too
far.
The administration of regulations in Sri Lanka is arguably poor,
which means our companies operate within both the black and
white, as well as the grey areas of the law. And they dont disclose
information when they dont need to.

Government securities is a highly-regulated market, and

there should be a paper trail within the Central Bank, and
the State-owned funds, that explains the 10 billion rupee
profit made by Perpetual Treasuries
This is why dialogue and negotiations with market participants,
and fine tuning of regulations, has to be done constructively and
on a continuous basis but I may be getting ahead of myself
here.
Along with profit maximisation is the hallowed concept of the
private ownership of land and capital, a natural right, it is
believed this, together with political systems of hierarchy and
subservience, means the trifecta is complete.
Of course we will be called communists by our democratic
allies, if we question any of these hallowed principles, so this
writer wont go there just yet.
The urgent matter at hand is whether we forge our own path in
negotiating a just economic system, and whether we name and
shame a few companies while doing so these days, at least, it
seems just one company in particular or are there alternatives?
Facts of the case

While the facts of the matter are murky, what can be said clearly
is the following:
Many argue there has been complete collusion, not just between
this company and the hierarchy of the Central Bank, but also at
the highest levels of Government. This enabled the company,
Perpetual Treasuries, to make 10 billion rupees in tax-free profits,
which is a tenfold growth during a 14-month period.
The allegation continues that there was collusion with State
pension funds, and the Central Bank, the designated supervisor
and regulatory body, deviated from its regular function of
monitoring and regulating the bond market, during this period.
Perpetual Treasuries, as a result, borrowed from the Central Bank
repo window and other sources, and through highly leveraged
positions, took positions that enabled massive profits, not once,
but repeatedly.
But there are other arguments, and these deserve due
consideration too.
Counter arguments

Primary dealers, according to the current state of

regulation, are allowed to leverage up to 10 times their capital.
Although many companies would not take the risk of wiping out
their capital, Perpetual Treasuries, it seems, took highly leveraged
positions through various options.
They either did this with perfect information, or they could predict
the movement of interest rates in the illiquid and one-sided
bond market, or they were willing to gamble their capital, given
their view on interest rates.
Its worth noting that some companies do this in developed
markets too.
However, the supportive stance of State pension and long-term
funds is essential to complete the equation.
What we do know
Even non-participants in the Sri Lankan bond market, can say a
few things with clarity.

The Government had a predictable and massive budget deficit

last year. In fact, Sri Lanka runs twin deficits every year.
Tax revenues were predictably lower, Government spending
escalated, and a sharp outflow of foreign funds from the bond
market, to the tune of 1.5 billion dollars thanks to the exit of
Franklin Templeton, blew a huge hole in the balance of payments.
Given the heavy domestic and foreign borrowing requirement,
(during an election year in which rates apparently dont go up),
the sharp decline in foreign reserves, and the need to resort to
IMF funding and to protect the currency, the pressure on interest
rates were clear they were heading up.
Bit more analysis
With a bit of analysis, one can reach a few more conclusions
about the situation in Sri Lanka.
Given the massive annual borrowing requirement of the
Government, interest rates would continuously spike upwards if
left to market forces.
The sheer volume of the borrowing program means the market is,
arguably, one sided.
Without the savings and participation of long term funds,
especially the State pension, savings and insurance funds, the Sri
Lankan Government would not be able to meet its annual
borrowing requirement.

The amount of savings the Government can access locally,

outside of captive sources, is rather small. This means the
Government has to compete with the private sector for these
funds.
This competition in the secondary market is what gives the
semblance of a demand and supply situation, the price of which is
called market interest rates.
In other words, with the captive involvement of State funds, Sri
Lanka does not have what can be called a properly functioning
market.
"Given just how massively overstaffed and politicised the
Central Bank is, it is possible that information suggesting
that the issue would be upsized leaked from somewhere
else. Information suggesting the issue would be upsized,
as opposed to perfect information, may fall into a grey
area on inside information. Whether the break from
procedure to improve market performance, and naivet
that his son-in-laws company was suddenly highly active
in the market, was what really happened naivet can
also stem from bad advice the real question here is
whether there was inside information. And that too from
the mouth of the Governor. The jury is still out on that, in
my opinion"
Captive funds continuously roll over their portfolios and purchase
treasury bonds. If they do not do so, the Government would go
bankrupt. At the same time, the funds would not be able to
manage their massive portfolios. The EPF portfolio, for instance,
manages 1.8 trillion rupees which are mostly in treasury bills and
treasury bonds.

With predictable pressure on interest rates, and predictable

buyers for bonds, a market participant may be able to map out a
strategy by leveraging their positions, and arbitrage between
short and long-tenure bonds or so the argument appears to be
from the Perpetual Treasuries side.
Theoretically, at least, this appears to be possible.
COPE report
According to the interim COPE report, the Government funding
requirement, expected for March 2015 in late February 2015, was
to the tune of 261 billion rupees, an exceptionally high month it
would be met by issuing 89.6 billion rupees in treasury bills, and
172 billion rupees in treasury bonds.
The report doesnt explain why this was an unusual month. But
the month follows elections held in January, and several months
of auctions not being held.
The then Governor Arjuna Mahendran approved raising 40 billion
rupees through the issuance of 20-, 30- and 50-year treasury
bonds, of 10 billion rupees each, and noted that EPF, NSB and
SLIC should stabilise rates.
This was however not implemented as approved, the report
shows. Actual funds received during the month of March
amounted to 185 billion rupees. The implications of this shortfall
are also not explained.
The report further states that Central Bank officials, who are
unnamed, were worried that there was a risk of being unable to
raise all the money in March by resorting to direct placements.

The writer of the report concludes that these concerns were

unwarranted.
The dismissal of the concerns of Central Bank officials, the lack of
detail on these particular events, and the short statement
recorded from the EPF, suggests possible bias on the part of the
author.
What happened on 27 February?
Mahendran subsequently explained, when speaking to media,
that his general intention was to increase market participation in
the bond market so as to build a more vibrant secondary market.
Maybe he suddenly upsized the primary auction bond issue on 27
February from one billion rupees to 10 billion rupees, for this
reason, given the perceived shortfall in March.
In theory, at least, this is possible.
A careful market participant may have been able to guess that
there was a serious shortfall in March, given the disclosures on
the Government borrowing program and maturity profiles.
They may then have aggressively bid in the hope of getting lucky.
The dominant argument, however, is that they had inside
information that made this aggressive bet worthwhile.
Inside information

Given just how massively overstaffed and politicised the Central

Bank is, it is possible that information suggesting that the issue
would be upsized leaked from somewhere else.
Information suggesting the issue would be upsized, as opposed to
perfect information, may fall into a grey area on inside
information.
Whether the break from procedure to improve market
performance, and naivet that his son-in-laws company was
suddenly highly active in the market, was what really happened
naivet can also stem from bad advice the real question here is
whether there was inside information. And that too from the
mouth of the Governor.
The jury is still out on that, in my opinion.
50 basis point rate cut
The other significant allegation is that the 50 basis point cut in
policy interest rates in April last year, by Mahendran, was to
further the goals of this primary dealer.
By association, this allegation assumes the Finance Minister, the
Prime Minister, and the Monetary Board all colluded on this
decision, since our Central Bank is by no means independent.
According to the monetary policy statement that month, the
decision was made to boost economic growth amid low inflation.
While again benefiting those who hold a significant portfolio of
bonds, it is possible that Sri Lanka followed what 20 other
countries did.

The Finance Minister, who strongly favours low interest rates, may
have been involved in this scenario.
Given the upward pressure on interest rates, and this strange
policy cut, all market participants should have been able to
position themselves vis--vis their expectation on future interest
rates, and arbitrage short and long-tenure bonds.
Predicting interest rates
Predicting interest rates is not a science, but even this writer
believes that uncertainty ahead of securing IMF funding would
drive interest rates up. Positive news that Sri Lanka secured IMF
funding would drive interest rates down.
Similarly, a two percentage point move in secondary market
interest rates, after tightened policy, is likely an exaggeration,
and there should be a dip, while a delay to VAT implementation
should drive interest rates up.
News of a successful sovereign bond issuance would, similarly,
put downward pressure on interest rates.
Arguably, these were some of the major patterns, seen during the
last year.
The other possibility, of course, is that market rates are
continuously manipulated by the few players in the market if
this happens in stocks, it can happen in bonds.
Paper trail

At any rate, Government securities is a highly-regulated market,

and there should be a paper trail within the Central Bank, and the
State-owned funds, that explains the 10 billion rupee profit made
by Perpetual Treasuries.
If there was a regulatory lapse, while these trades were being
done, then there should be a paper trail on that too.
If the Central Bank did not have the necessary skills to monitor
these highly leveraged trades, then it should admit to that, and
boost its supervisory capacity going forward.
Economic priorities
To draw this long-winded and heated debate towards a
conclusion, the opinion of this writer is that there are significant
issues in every sector of the Sri Lankan economy.
SriLankan Airlines and Mihin have accumulated losses of 128
billion rupees, and total debt of 3.25 billion dollars, or 474 billion
rupees, while cancellation of aircraft purchases recently cost the
island 170 million dollars, or 25 billion rupees, in penalties,
according to Reuters.
Perpetuals 10 billion rupee profit pales in comparison.
If there is an economic first priority in the country, it is fixing this
airline. There should be regular commissions and reports naming
and shaming everyone concerned, from consultants to advisors,
since naming and shaming seems to be the preferred way of
doing things, and appears to gets things done.

Similarly, CPC, infrastructure and power sectors, bleed the

country dry. The banking system is guilty of not providing loans to
small and medium sized enterprises, while foreign banks play out
Sri Lanka all the time, in everything from syndicated loans, to oil
hedging contracts.
Primary dealer Entrust went bankrupt with over 10 billion rupees
down the drain, CEO bonuses and perks, across the board, are not
even discussed, while people clearly named in the Panama Papers
have not been investigated.
There is a lot of naming and shaming that needs to be done all
these numbers are staggering.
Conclusion
What is happening in bond trading should certainly be
investigated, but to make Perpetual The economic story in the
country smacks of political bias. Despite every argument that this
supported the Government, the coalition was the big loser in
these scandals.
Related to this is how we go about fixing the economy.
Naming and shaming is a rather archaic way of doing things,
and a more evolved approach would be one of constructive
dialogue.
This means discussions with market participants, and fine tuning
of regulations on a continuous basis arguably, there is no
regulation in this island that doesnt need to evolve regularly.

If individuals in the Panama Papers are investigated, give them

the opportunity to bring back the funds, pay a penalty, and have
a broad amnesty for what has been done. This seems the only
way to ensure results.
Right now we have no results whatsoever.
While the option should be retained, heavy-handed approaches
dont seem to work. Otherwise I have no qualms against them.
Going forward, Sri Lanka needs a new approach in dealing with all
of these economic problems. It must also find a progressive
approach.
(Chamath Ariyadasa is the Editor for Lanka Business
Online. He was a bureau chief for Dow Jones Newswires in
Colombo, and has an MA in the social sciences.)
Posted by Thavam