Central Bank enhanced foreign reserves - Deputy Governor

by Shirajiv SIRIMANE

The Euro zone crisis is not yet over; India and China, which were not so badly affected by the global economic crisis, are now showing cracks in their economies while Australia last week reported that its unemployment rate has increased.

However, Sri Lanka continues its development drive and is maintaining a high economic growth of over eight percent and a single digit inflation. The Euro Zone crisis had not affected Sri Lanka and the Central Bank is also maintaining high foreign reserves. The Central Bank has generated substantially high returns on its reserve management, which clearly indicates that its overall risk management practices have been effective and profitable, and that its pool of investments had been made in a wise and prudent manner.

Deputy Governor of the Central Bank, Ananda Silva, referring to criticism levelled at the Central Bank by the Opposition that the Bank has invested in Greek Government Bonds and that a huge loss has been incurred as a result, said as a policy, the Central Bank manages the country's foreign reserves to safeguard and enhance the value of its overall reserves as well as to generate a reasonable income from its investments.

"The track record of the international investment activities of Central Bank, over the past 25 years, is very creditable, with the returns generated by reserve management activities over the past two years being well above those of the previous years'. It had yielded US$430 million in 2011 and US$341 million in 2010. In fact, these are the only two years in the history of the Central Bank that returns have exceeded US$200 million.

"Further, 2011 was also the first time in 20 years that the returns exceeded six percent over the US Fed Fund average. The yield in 2011 has been after making provision for all losses, which clearly shows that the portfolio management has been highly successful in enhancing the value of the total portfolio, while also providing for any losses that had been incurred in a highly challenging and volatile global situation," he said.

He said, "It must also be said that the investments of international reserves are carried out by the Central Bank on a "pool" basis. When investments are made in that manner, the valuation and profit of the entire "pool" of investments must be assessed, instead of merely looking at the performance of individual investments on a piece-meal basis.

High returns

"Particularly over the past two years, the Central Bank has generated substantially high returns on its reserve management, which clearly indicates that its overall risk management practices have been effective and profitable, and that its pool of investments had been made in a wise and prudent manner. While doing so, there has also been a necessary trade-off between different risks, within the governance framework. "It may also be pertinent to state that the profits made by the Central Bank from its investment of foreign reserves for 2006 - 2011 were US$1,243 million (about Rs.137 billion), which is higher than the profits made during the previous 10 years."

The investment in the Greek Bonds was in line with the Central Bank's policy and the necessary approvals had been obtained. "These Greek bonds had been purchased in keeping with Foreign Exchange Reserve Management Guidelines. These guidelines have been approved by the Monetary Board, initially in November 2003 and thereafter amended from time to time, in keeping with evolving circumstances, to empower and guide the officials of the Central Bank to manage the international reserves.

Excerpts of the interview:

Q: The Opposition Leader has said that the Governor of the Central Bank had invested in Greek Bonds, without considering the circumstances surrounding the investment. He has also alleged a lack of governance and a breakdown of good sense in the management of foreign reserves by the Central Bank. How do you respond to this?

A: Unfortunately, such offensive reports are driven by political considerations. In fact, the Opposition Leader seems to be mainly interested in laying the blame on the Central Bank Governor for anything which he considers detrimental. But whenever anything beneficial to the country and the economy happens due to Central Bank action, he is understandably silent. You may even remember that he called me a "missile" worse than the Agni missile! I am getting used to such reactions now.

However, leaving all that aside, the Central Bank's decision to invest in the Greek Bonds was based on the trade-off between different risks faced, and the Central Bank's tolerance of a higher risk on a very small part of its portfolio (the investment in Greek Bonds was 0.6 percent of its portfolio). Such a risk tolerance was possible, particularly in view of the substantial gains that had been made by the Central Bank during 2010 and 2011, and the possibility of earning a higher yield on an investment in Greek bonds.

Decision to invest

In that context, while it will be acknowledged that Greece was rated 'B1' at that time by Moodys, it would also be noted that Sri Lanka's own rating was the equivalent of 'B1' from Moody's. Let us also not forget that even at that time overseas investors had invested US$ 2,000 million in Sri Lanka's International Sovereign Bonds and about US$ 2,200 million in Sri Lanka Rupee Treasury Bills and Bonds.

As is well known, the investments in the Sri Lankan bonds had been made by many investors from all parts of the world. This shows that investing in high yielding sovereign paper had been an integral part of fund management of many Funds in the world. The Central Bank too had followed a similar practice in investing in the bonds.

The decision to invest was also influenced by the fact that at that time, there was a robust framework in place for crisis management in Europe supported by several large funds.

This package consisted of about €750 billion, which was contributed by the European Financial Stability Mechanism with €60 billion, the International Monetary Fund (IMF) with assistance of €250 billion, and the European Financial Stability Facility (EFSF) with €440 billion.

In fact, the EFSF, which enjoyed a rating of "AAAA" by Moody's, was specifically created by the Euro Area member states in May 2010, to implement several crisis management instruments, with the specific mandate to safeguard the financial stability in Europe by providing financial assistance to Euro area member states.

According to its mandate, the EFSF had the power to provide loans to countries in financial difficulties; intervene in the debt primary and secondary markets; act on the basis of a precautionary program and to finance recapitalisations of financial institutions through loans to governments.

In the background of these institutional frameworks being available to Greece, the risk of Greece defaulting was considered to be reasonably low and tolerable in the circumstances, since there was a legitimate expectation that the economically strong European countries will not let down a country within the European Union.

But, unfortunately the support from the stronger European Governments had not been forthcoming towards Greece as expected when the difficulties increased, and it had appeared that there was a chance that the big European powers were going to let Greece down. As soon as it was realized that such a situation could materialize, the Central Bank had taken the measures necessary to exit from the investment gradually.

Let me also state that the Central Bank's investment in the Greece bonds was of a face value of Euro 30 million, but at that time there was as much as Euro 292,000 million worth of bonds that had been issued by Greece. Further, as of today, there are several trillions of Euros of European bonds outstanding

Let me also remind you that even as of today, Europe is considered one of the strongest economic regions in the world economy, even though they are going through some tough times. As a result, when bonds are issued in the European currency by a member of a European Union, many investors still take the view that Europe will honour its commitments and continue to invest, even though they may have lost out in the case of Greece.

Q: Internationally, the benchmark safest investment is considered to be in US Treasuries. On that basis, a risk averse Fund could decide to place its funds in US Treasuries only, and thereby suffer no loss. Why didn't the Central Bank follow such a path?

A: If the Central Bank had followed that total risk averse path, and invested the entirety of its average reserves of last year, amounting to about US$ 6,500 million, in two-year US Government bonds, the total return that the reserves could have earned would have been about US$16 million only.

As against such a benchmark return, the Central Bank has been able to generate a total income of US$ 430 million, through its investment strategies, which then works out to US$ 414 million more than the return that would have been yielded on the supposedly "no risk" instruments. Technically, then, the Central Bank would have "lost" US$ 414 million if it had invested in the US Treasuries! That is about Rs.47 billion!

No risk-free instruments

In any event, it must be clearly understood that there can be no instrument which could be considered to be 100 percent risk free. In fact, even the supposedly 100 percent risk-free investments in US Government Treasuries were under a cloud of a possible default in August 2011. Had legislation not been passed in August 2011, the resulting situation may have pushed US treasuries into a default mode, with perhaps horrendous repercussions for the entire global investment community with huge losses as well.

Q: Some analysts have pointed out that sufficient attention may not have been given to the fact that Greece's credit rating had been below investment grade, and that such a situation could have never arisen had all investments been made in higher rated instruments or countries only. What do you have say?

A: Every international investor knows that good quality credit is available even in countries with credit ratings below investment grade, as could be seen in the case of Sri Lanka. Just last week, we saw Sri Lanka's bond offering of a 10 year US$1 billion being over-subscribed by over 10 times. The interest rate that Sri Lanka got of 5.8 percent was lower than Italy's current 10 year bond rate of 6.2 percent and Spain's 7.2 percent. Both those countries are investment grade countries!