Domestic debt optimization (DDO) - Why it is a flawed and deceptive proposal. Let us examine insights.

 

The media these days is full of news of the government's plan to restructure its domestic debt through the restructure of Treasury bonds held by superannuation funds led by the EPF. The central bank (CB) presents that this is the only option available to the government to make its domestic debt sustainable in order to avoid a near-term default similar to the default of foreign debt on 12 April 2022. The CB also presents that this is the best option available to superannuation funds to protect their interests of the members. 

The Parliament's Finance Committee also took up this subject for consideration last week and seems to have given the concurrence after assessing the loss outcomes of the DDO proposal based on information submitted by the CB.

Therefore, this short article is intended to shed some light on the false information presented by the CB on this subject despite the fact that the CB has been managing the public debt for the past 73 years.

Can superannuation funds make domestic debt sustainable?

The answer is "it cannot." The reason is bluntly seen from the data as cited below.

• Domestic debt stock as at the end of 2022 : Rs. 15,033.8 bn

• Total assets of superannuation funds : Rs. 4,345 bn (i.e., Rs. 3,459.9 bn of the EPF, Rs. 468.8 bn of the ETF and the balance Rs. 416.3 bn of other funds)

• Investment of superannuation funds in domestic debt : Rs. 3,953.8 bn which is only 26.3% of the domestic debt stock.

• Therefore, even if the government freezes or writes off all debt raised from superannuation funds, domestic debt stock will not decline to a sustainable level, given the acute profile of the present fiscal front.

• Further, the debt restructuring proposal (DDO) is 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) which involves only in reducing the burden of interest payment component in debt service on Treasury bonds held by superannuation funds. However, the CB has not publicized relevant figures how the proposed reduction in interest rates payable to superannuation funds would make the present domestic debt stock (Rs. 15,664.5 bn in April 2023) sustainable.

Two restructuring options available to superannuation funds

• Accepting the exchange of existing Treasury bonds for new Treasury bonds at lower interest rates.

• If not opted for the option above, being subject to 30% of tax on investment income of superannuation funds in place of 14% tax at present.

As such, the proposed debt restructuring is targeting a reduction of the flow of interest payment on domestic debt (so called debt sustainability in the DDO proposal) or an increase in the tax revenue of the government to enable it to enhance its debt service ability.

This appears to be similar to the modus operandi followed by the government of Ghana for its DDO options applied for all investors in government securities.

Figures cited by the CB Governor at the Finance Committee meeting covered in the attached video

At the said meeting held last week, following figures and information were cited to show the impact of the proposed DDO on superannuation funds. This was based on assumptions-based projection of the growth of a fund portfolio of Rs. 100 bn during the proposed restructuring period from 2023 to 2038. see the video https://www.youtube.com/watch?v=HzCSLcZqPI0

• The portfolio will increase to Rs. 387 bn if the portfolio grows as it is without participating in any restructuring option.

• If participated in the debt restructuring, the portfolio will increase to Rs. 369 bn showing a reduction of the portfolio by 4.8% as compared to no restructuring position.

• If the restructuring option is not exercised and the portfolio is subject to 30% tax, the portfolio will increase to Rs. 304 bn showing a reduction of 21.6% as compared to no restructuring position.

• The 4.8% reduction is arrived at the assumption of the ability of the government to continue debt rollovers at current interest rates.

• However, as the current debt stock is unsustainable, there is no status quo. Therefore, the government will have to default domestic debt very soon as was done on foreign debt whereas this position also has been informed to the Supreme Court through an affidavit filed by the CB Governor.

• Accordingly, the Finance Committee praised the DDO on the ground of 4.8% loss to superannuation funds on debt structuring DDO option as compared to 21.6% loss due to 30% high tax DDO option.

Inapplicability and deceptiveness of the debt restructuring proposal

Information presented above establishes that the DDO proposal as presented by the CB is baseless and contains false data as highlighted below.

• Domestic debt stock of the present level (Rs. 15,665 bn) cannot be made sustainable from the present DDO proposal.

• The government does not have to default debt in sovereign currency as it always has the ability to rollover debt through the creation of credit at the contemporary interest rates structure partly determined by the central bank's monetary policy. The government has this ability as the domestic debt is reflective of the risk-free investment portfolio of the private sector (banks, shadow banks, businesses and households). The default of the foreign debt in Sri Lanka was in fact a default of foreign currency payment by the CB. Therefore, the domestic debt unsustainability and the fear of the near-term default as cited by the CB Governor are baseless notions unless there is another hidden, fresh conspiracy to make the government default and bankrupt the country further.

• The projected growth of the portfolio of Rs. 100 bn as presented at the Finance Committee is baseless as debt service at current interest rates is assumed for the estimation of the future growth of the portfolio until 2038. While this assumption is unpractical for a central bank which conducts the monetary policy and drive interest rates in the economy, the organic growth of a superannuation portfolio largely depends on the net contribution which is a combined result of new employment, retirement and wage rates in the future. For example, if the young and adults migrate the country at the current rate along with the ongoing aging profile and ongoing economic contraction, the organic growth of superannuation funds could be negative in the next decade. Therefore, the use of the CB's projections for the DDO as proposed has no professional or macroeconomic basis.

• The DDO as proposed is a type used in restructuring of bankrupt business entities in order to improve the quality of financial conditions (the balance sheet and income statement) for regaining the financial solvency. The application of this model as it is for governments is not appropriate because the fiscal front (government finance) is operated on various macroeconomic and public interest principles and objectives that are opposite to operations of business entities. Further, the government does not have standard financial statements to assess the debt position. This model failure is evident from many countries which continue to struggle in decades after debt restructuring exercises.

Therefore, it appeared unusual for Finance Committee experts to accept CB figures as divine-correct and endorse the DDO option at 14% tax over the table.

Concluding Remarks and Concerns

• It is questionable that the CB continues to manage public debt despite the hard fact that it has managed public debt for the past 73 years with international expertise to the present unsustainable level. Therefore, the same debt manager and officials trying to make debt sustainable now through such baseless DDO proposals is a grave concern over the governance.

• The present DDO proposal targets the EPF which is about 80% of the superannuation sector assets whereas the same CB (Monetary Board) has been the financial manager of the EPF throughout the past. Therefore, the conflict of interest is a grave concern observed in the DDO governance. It is not secret that the CB has been using the EPF unduly for debt management and monetary policy's interest rates control simultaneously at the expense to the EPF. As the CB Governor is the chief of both public debt management and EPF financial management, he cannot not expected to act at arm's length of the good governance to balance the interests between the debt and EPF. Accordingly, the present DDO proposal is a fresh attempt to abuse the EPF in a new model of macroeconomic mismanagement.

• If the CB Governor being the manager of public debt declares that domestic debt is unsustainable and likely to be defaulted soon, the superannuation sector (EPF, ETF and others) which has invested its almost all member funds in domestic debt due for default is also unsustainable now. This will be a grave public issue on the lives of the aged and retired population in the country. Therefore, what is immediately required for the government is to guarantee benefits to employees present and future if the government wishes to prevent a social rise potential in the near-term by maintaining the public trust in the system of the government. The situation world be unmanageable as the new CB will not be able to bailout banks hit by a liquidity crisis due to repeal of lender of last resort powers in the new Act.

• The declaration  of the domestic debt unsustainability and the near-term risk of default by the CB Governor at the Finance Committee casts doubts on the stability of the banking and financial system too as the system's liquidity and trust are built on investments in govt domestic debt. Therefore, the resilience of the banking/financial system as viewed by the authorities is highly questionable. In that context, the CB Governor's declaration as above is a serious matter to be investigated independently, given systemic risks connected.

• Restructuring of debt raised in sovereign currency is an unnecessary concept not warranted in modern macroeconomics.

• The discrimination of domestic debt in the DDO proposal between superannuation funds and other investors could lead to concerns over the violation of fundamental rights guaranteed by the Constitution of the country.

• Therefore, the present DDO proposal would no doubt open up further sources of the instability to both the government and the economy and delay the recovery from the present foreign currency and debt crisis caused by the CB itself.

• It is of grave concern as to why the CB being the failed public debt manager continues to manage public debt despite the fact that the government has hired international debt management experts for the purpose and the Parliament has approved of setting up an independent debt management office.

• The recommendation of the Finance Committee to the CB Governor to talk only to economists rather than activists is also flawed as the CB Governor's DDO has no economics while professional economists are not seen so active in the country.

• It is hard to understand why such a DDO is proposed if superannuation funds will not incur any losses to their members due to the DDO whereas the EPF will be guaranteed the returns it received in the past as frequently stated by the authorities. It is the common sense that any restructuring of debt is intended to bailout the borrower at the expense of the lender. Further, the fondly reason expressed by the authorities to exclude banks from the proposed DDO on the ground of the financial system stability is baseless because financial system stability cannot be separated in the way the authorities wish. Therefore, the relevant authorities must reveal the bare truth to the public as they cannot deceive the public all the time.

• Overall, the proposed DDO is a meaningless waste of another bureaucratic act costly to public funds.

• Therefore, domestic debt unsustainability and the potential for a near-term default stated by the CB Governor at the Finance Committee are just his personal presumptions and views and, therefore, are not reflective of the facts, some of which are presented in this article. In that context, the contents of the affidavit referred to by the CB Governor at the Finance Committee may be questioned on grounds whether what have been sworn are the facts or unjustified, personal presumptions relating to unknown future that are not appropriate for making national decisions of this nature.

(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)