CB Governor alerts a near term default of govt domestic debt! Is the alert justified? What is the govt stance? Is the DDO sustainable to diffuse the alert?

 

The CB Governor at the Parliament's Finance Committee held last week alerted for near term default of domestic debt given its unsustainability unless the domestic debt optimization (DDO) is implemented as proposed without delay. The part of the video circulated in the media covering the alert is attached here. https://www.youtube.com/watch?v=HzCSLcZqPI0

He further revealed that this position had been already informed to the Supreme Court through an affidavit filed by him. Therefore, this default alert is now a legally written event by a high ranking public official in the capacity of the chief of the independent central bank that manages the public debt, fiscal agent, fiscal adviser, monetary policy and financial sector regulation together. Further, it is the CB Governor who led the default of foreign debt on 12 April 2022. 

Therefore, the alert should not be taken lightly although the government or the Treasury or the Finance Committee/Parliament has not responded so far, because if things go wrong in line with the alert unexpectedly, no one will bless the government.

Therefore, the purpose of this short article is to establish facts that the said alert is a falsified, unwarranted and irresponsible act of the CB Governor whereas the proposed DDO cannot have any meaningful impact or ease on the domestic debt stock.

Fact 1 : The alert's basis, unsustainability of domestic debt, is false

The CB Governor did not interpret his version of the unsustainability as there is no standard definition or measurement of domestic debt unsustainability. The modern monetary economics does not accept the possibility of default of debt raised by the government in sovereign currency unless the government defaults it purposely for political reasons. 

The underlying economic reason for non-default is the systemic ability of the government to rollover debt in sovereign currency through the creation of money and the willingness of the private sector/investors for the rollover of their investment in public debt. This is possible due to several reasons.

• First, domestic monetary system is created and built on the sovereign currency and reserves regulated by the government where the government operates on domestic currency.

• Second, the financial system is largely built and maintained on government debt held by the central bank, banks, shadow banks, businesses and households as their safe, liquid assets. Therefore, the sale of new debt and rollovers at current interest rates are a routine part of the financial system. For example, despite such alerts and default sovereign rating, the government has been raising weekly about Rs. 150 bn - Rs. 200 bn from auctions of Treasury bills alone. Here, the only challenge is the monetary policy noises that cause unnecessary and unjustifiable volatilities of interest rates in credit markets. For example, yield rates of government securities were pushed to 25%-33% during the second half of 2022 where current rates have prevailed at around 14%-20% without a major decline owing to monetary policy dealings. Therefore, a major source of the unsustainability of the domestic debt if the alert by the CB Governor is accepted is the unestablished supper monetary tightening pursued by the CB Governor since April 2022.

• The domestic debt stock as at end of April 2023 was Rs. 15,664 bn representing 58.4% of the total debt stock. However, there is no any benchmark to state that this stock is unsustainable and runs the risk of near term default. Nearly 87.9% of the domestic debt stock is government securities and the balance is bank advances. Therefore, there is no risk of lenders not rolling over the debt at any circumstances, given their trust in the government and the dependence of the financial system on domestic debt.

• The numbers based on GDP and debt information cannot support such alerts because debt involves different economic and social performances. For example, the Public debt stock in the US (US$ 31.5 tn) has risen to 129% of GDP where its interest cost on debt rollovers has surged to 5% currently from around zero in 2020-2021. Further, nearly 31% of the debt stock is to mature within a year (excessive bunching problem). However, nobody alerts for any situation of debt unsustainability or a near term default even if the political crisis on the debt ceiling recurs annually at the Parliament and monetary policy continues to be tightened at an unprecedented rate. Therefore, debt sustainability assessments without assessing economic and social performances underlying debt are bias and baseless.

Therefore, domestic debt unsustainability and near term default are baseless, personal presumptions.

Fact 2 : DDO to comply with the request of foreign creditors for debt burden sharing

Initial clarifications provided by the authorities show that the DDO has been proposed to facilitate the request made by foreign creditors at initial rounds of discussion on foreign debt restructuring where foreign creditors insisted on sharing the debt burden by all foreign and domestic creditors. This was a result of the IMF version of debt unsustainability in total debt.

This burden sharing position is evident from two official documents stated below. Both documents talk on fairness in sharing of the debt burden by all creditors, foreign and domestic, where nothing is mentioned about domestic debt unsustainability or any risk of near term default.

• Debt Restructuring in Sri Lanka, Presentation to the Cabinet of Ministers made by the CB Governor 28 June 2023

The slide no 13 titled "Discussions are underway for foreign debt restructuring" states, 

• "The need for sharing the burden of the envisaged debt treatment between both the foreign and domestic creditors has been highlighted by the creditors."

• DDO policy announcement released by the Ministry of Finance on 4 July 2023 

Para 3 of the document is - "The Domestic Debt Optimisation (DDO) is being carried out consistent with the EFF, to contribute to meeting the Debt Sustainability targets agreed upon with the IMF. 

• It is justified by the ambitious nature of these targets, the need to manage Sri Lanka’s public debt rollover risks in the future and the imperative of ensuring a fair contribution from all creditors to the resolution of Sri Lanka’s debt problem, without however jeopardizing the stability of the domestic financial system."

However, the notion of the fair sharing of debt burden stated above is violated by applying the proposed DDO only to superannuation sector.

Fact 3 : DDO proposal being insignificant on domestic debt stock

The DDO proposal is to reduce the burden of domestic debt service by restructuring of Treasury bonds held by the superannuation sector, i.e., EPF, ETF and other pension and provident funds. The facts given below prove that the proposed DDO cannot provide any ease on the present domestic debt stock.

• As at end of 2022, total investment of superannuation funds in Treasury bonds was only 24.7% of the domestic debt stock (Debt stock : Rs. 15,033.8 bn, investment of superannuation funds in Treasury bonds : Rs. 3,720 bn).

• The DDO proposal does not involve in any haircut on the face value of Treasury bonds held by superannuation funds. Therefore, there will not be any reduction in domestic debt stock.

• The DDO proposal involves only in restructuring of debt service profile through the exchange of Treasury bonds held by these funds for 12 new Treasury bonds carrying new interest rates/coupon rates of 12% (up to mid 2026) and 9% (from mid 2026 up to maturity from 2027 to 2038) (or face a tax increased to 30% from the present 14% on all investment income of the funds). Therefore, the DDO proposal is expected to reduce the annual interest payment on Treasury bond stock accounting for less than 24.7% of the domestic debt stock. However, the CB has not publicized relevant figures how the proposed new interest rates payable to Treasury bonds held by superannuation funds would reduce domestic debt burden or debt service.

• Total interest payment on Treasury bonds during 2022 was only 55.4% of total interest payment on domestic debt. Accordingly, interest payment on Treasury bonds stood at an overall rate of 9.1% on the face value of bonds (Rs. 796.4 bn on Rs. 8,709.1 bn). Therefore, the DDO proposal involves only in Rs. 340.2 of interest payment to superannuation funds or 23.7% of interest payment on domestic debt (Rs. 1,436.6 bn in 2022). Therefore, any ease on interest payment on the domestic debt stock cannot be expected from the DDO proposal.

• Further, proposed interest rates for new Treasury bonds to be exchanged for existing Treasury bonds are 12% and 9% as compared with the effective annual interest payment of 9.1% in 2022 on existing Treasury bonds to all investors. Therefore, new interest rates (12% and 9%) on restructured Treasury bonds to be held by superannuation funds cannot provide any ease on the stock or servicing of domestic debt.

• The segregation of the superannuation sector from other investors in domestic debt is also an unethical and unfair act of the state as the superannuation sector represents only a small portion of 13.9% of the formal sector financial institutions system. The arm's length principle applied in good governance is also abused in the DDO proposal as the state managed superannuation funds (i.e., EPF and ETF) account for nearly 92.4% of the superannuation sector targeted in the DDO.

Financial stability risks underlying the CB Governor's alert

As the alert is made by the CB Governor, it must be taken seriously as an officially valid alert that may have been supported from a set of unpublic information available to him, given his access to information. Therefore, the alert also reveals a significant exposure of the economy to systemic risks, given the concentration of the monetary and financial system in the domestic debt profile due to several facts.

• Monetary and banking system is built on domestic credit to the state sector. For example, nearly 75% of of country's M2b money supply as at end of 2022 is the credit granted by the banking system to the state.

• The liquidity and trust in the monetary and banking system are built on government domestic debt as a significant portion of bank capital and deposit liabilities has been invested in government debt. For example, nearly 53% of liquid assets of the banking sector as at end of 2022 was held in Treasury bills and bonds. If bank advances to the government are included, the ratio will further rise. It is not mentioned that the state banking sector being the core of the monetary and banking system in the country runs on the strength of credit operations with the government. Banking system is already in stress liquidity conditions consequent to super tight monetary policy implemented since April 2023.

• Given the above position, unsustainability and near term default of domestic debt as alerted by the CB Governor are no doubt direct sources of a systemic financial crisis that could be possible in the near term. It is this fact that led the CB Governor to declare at the night of 25 June a sudden bank holiday of straight 5 days from 29 June when the DDO proposal was to be taken up at the Parliament at the week end. The CB Governor clarified that the purpose of the banking holiday was to avoid any banking and financial market instability and any impact on bank deposits and interest rates during the process of the DDO approval in the Parliament. It is not a secret of the liquidity panic created by this holiday announcement news despite the assurance of the CB Governor and the provision of fresh liquidity of a significant volume by the CB to resolve the panic because of the systemic importance of government debt in the monetary and financial system.

Therefore, the CB Governor's alert may have already given due effects to the CB's macroprudential authority and proposed Financial Sector Crisis Management Committee as reported in its Annual Report 2022 because the frequent story of resciliance is now cracked by the CB Governor's alert.

Public concerns requiring immediate action of the government

Facts presented above reveal that;

• The CB Governor's alert for domestic debt unsustainability and near term risk of default is an unreasonable and unwarranted act of a public official in the rank of the CB Governor.

• Even if the alert is acceptable, the present DDO proposal is an utter failure to resolve the debt situation. Foreign debt restructuring also has been dragging on for more than a year since April 2022, despite the colorful statements made by the relevant authorities. 

• Domestic debt unsustainability cited by the CB Governor for the present DDO proposal also is false and deceptive as the government to default on domestic debt does not arise on one hand and the DDO proposal does not have any favourable impact on the debt position on the other hand.

• Therefore, what has been presented to the Parliament through the Finance Committee last week and to the Supreme Court through an affidavit filed by the CB Governor also is false and deceptive. In this context, the CB Governor's alert for a near term default of domestic debt cannot be legitimised.

• As the alert has been made by the CB Governor on a subject that should be decided by the Minister of Finance and Parliament, the government must announce its stance to the public and act, accordingly. Otherwise, any event of domestic debt default that may hit in the near future as alerted by the CB Governor similar to foreign debt default on 12 April 2022 (assuming that he would not covertly act to advance it) due to unknown reasons would be a another macroeconomic and social catastrophe that can never be resolved.

• If the government does not accept the CB Governor's alert as I suggest above, disciplinary action must be immediately taken against his public misconduct in terms of the relevant provisions of the Monetary Law Act because his public duty is to resolve the public issues in the public interest without aggravating it through such means and alerts. This action is not unreasonable, given the fact that if a similar alert has been made by another individual in this magnitude (Parliament and Supreme Court), even the prosecution could be invoked on the ground of adverse effects possible on the smooth functioning of the public finance and the economy.

• If the politics continues to play on this critical macroeconomic subject, the continuation of macroeconomic disruption and contraction caused by the CB could be expected at a higher phase in several years to come.

(This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures.)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 12 Economics and Banking Books and a large number of articles published. 

The author holds BA Hons in Economics from University of Colombo, MA in Economics from University of Kansas, USA, and international training exposures in economic management and financial system regulation)