An assessment of the loss arising from the

bond scam
June 21, 2015, 7:48 pm

By Ajith Nivard Cabraal

Former Governor of the Central Bank of Sri Lanka
The loss to the government is mainly due to the higher interest burden
arising from the unnecessary and unwarranted increase in interest rates.
Over the past few weeks, the government has embarked on a mission to
stealthily brainwash peoplethrough carefully placed comments that no loss
has arisen due to the Bond scam.
Sri Lankas biggest ever economic scandal, the Bondscam of 27th February
2015 created a useful platform for researchers, analysts and opinion
makers to analyse, debate and comment on this unsavoury subject for
over four months. Since the primary analysis has already been done, the
priority now seems to be uncover the latent aspects of this scam so that
the country could cut the losses and bring the master-mind behind this
scam to justice. In order to do so, it is vital that politicians, academics,
intellectuals and the general public are gradually familiarized with the
technical issues and economic ramifications related to this subject.

As is well known, over the past

four months, various inquiries,
investigations and judicial
processes in relation to this scam
have been carried out by different
authorities. However, based on the
numerous articles and statements
on this subject by interested
parties, it is clear that some still
do not have a thorough
understanding of the different
aspects of this complex issue and
the subsequent masterly cover-up attempt. In addition, the magnitude of
the loss arising from the Bondscam has not yet been assessed in sufficient
depth, and hence, at this stage of the debate, it may be useful to carry out
a study of the losses from different points of view, namely the loss to the
government, the public, and the economy.
The loss to the government is mainly due to the higher interest burden
arising from the unnecessary and unwarranted increase in interest rates.
Over the past few weeks, the government has embarked on a mission to
stealthily brainwash peoplethrough carefully placed comments that no loss
has arisen due to the Bondscam. One such attempt was the suggestion
that the controversial T-bond was carrying a 12.5% coupon rate in the
initial offering, and, therefore, there was no additional cost to the
government since the controversial bond wasintended to be issued at that
rate! This recently made preposterous claim would have normally caused
some amusement in the financial circles, if not for the major damage it
caused to the credibility of the government.
Against that background, it is now necessary for all persons to understand
certain terms used in this subject, and in particular, the meaning of two
key terms: "coupon rate" and "yield rate". The "coupon rate", also referred
to as the "interest rate", is the percentage rate at which investors receive
interest from the Central Bank at six-monthly intervals on the "face value"
of their bond investments. It is generally fixed, and is specified at the time
of the initial issue of a particular bond series. The Central Bank usually
issues bonds by opening a new or an existing series at varying intervals
over a period of time until the total volume of the bonds issued under a
particular series reaches an optimum level. That practice is based on the
principle that the number of bond series in the market must not be too

excessive, as that serves to promote a vibrant secondary market. A

rational number of series also facilitates two-way quotes among primary
dealers which is a fundamental requirement for efficient trading in the
secondary market. At the same time, it enablesdebt managers to avoid the
undue fragmentation of the bonds issued. The "yield rate" of a bond is the
rate of return on an investment based on the market rate prevailing at the
time of the issuance of the bond, where such rate would almost always
vary from the coupon rate.
When the secondary market "yield rate" is less than the "coupon rate", an
investor will have to pay more than the "face value" of the bond in order to
buy the bond. E.g., if the yield rate on a 30 year Treasury bond is 11.1%
(including 10% tax), and the coupon rate is 12.5%, an investor, in general,
will be prepared to pay a "book value" of approximately Rs. 112/(described as "book value") to buy the Treasury bond of a "face value" of
Rs. 100. That would then provide him with the expected 11.1% for his
investment over the 30 year period. In the same way, if the secondary
market yield rate is more than the coupon rate, an investor will, in general,
be ready to pay only a "book value "which is less than the "face value" of
the bond in order to buy the bond. E.g., if the yield rate on a 30 year
Treasury bond is 13.9% (including 10% tax) and the coupon rate is
12.5%, an investor, in general, will be inclined to pay a "book value" of
approximately Rs. 90 to buy the Treasury bond of a "face value" of Rs. 100
since the bond would give him the expected 13.9% with a 30 year
maturity, at that price.
It is against the above background that the controversial bond of 27th
February 2015, which carried a 12.5% coupon rate with 30 year
maturitymust be considered. On that day, the yield rate that prevailed in
the secondary market for a 30 year bond was 9.35% (net of tax) or a yield
of 10.4% (with the tax). In those circumstances, an investor would have
been reasonably expected to pay about Rs. 119/30 to purchase a bond
with a face value of Rs.100/-. However, in a totally unexpected move,
which was also contrary to the prevailing policy stance in a falling inflation
environment, the Central Bank accepted T-bond bids at yield rates of
12.5% net of taxes, which worked out to a 13.9% yield rate including the
tax. By doing so, certain closely connected investors were generously
accommodated for issues of bonds, well beyond the originally intended
issue of Rs. 1 billion at a book value of aroundRs. 90, when the expected
price at that time for a bond of Rs. 100/- face value was as high as Rs.
119/30. This simple arithmetic shows that by accepting bonds at a
deliberately bumped-up yield rate of 12.5% (net of taxes) which was
significantly higher than the yield prevailing in the secondary market of

9.3% net of taxes, the government cash flow has suffered a tremendous
loss of Rs. 29/16 for each Rs. 100/- bond. (i.e. Rs. 119/30, less Rs.
90/17). That loss suffered by the government works out to a phenomenal
sum of Rs. 291.6 million for every Rs. 1 billion, and that colossal loss was
recorded in relation to the bulk of the bonds that were issued on that day
under this corrupt bond that was issued with gross impunity.
Unfortunately, the loss to the government did not stop at that point since
the impact of the artificially enhanced interest rate on the controversial 30
year bond had an effect on all subsequent bond issues as well. As is well
documented, the interest rates in the government securities market had
been on a clear declining trend from about mid-2014 onwards, and by
end-February 2015, the 3 month Treasury Bill rate was less than 6%, the
one year Treasury Bill rate was around 6.1%, and 30 year Treasury bonds
were trading at about 9.35% in the secondary market. In that scenario, by
accepting the 30 year Treasury Bond at 12.5% in highly controversial
circumstances, the entire yield rate structure in the Government securities
market underwent a significant shift upwards from 27th February 2015
onwards, leading to an unnecessary, unwarranted and unacceptable
additional cost in the future interest payments in the Government budget.
This situation could be seen clearly in the table depicting the Treasury bill
and bond rates prevailing before and after 27th February 2015 (See
table),as well as in the graph depicting the two yield curves, before and
after 27th February 2015.
Going further, a comprehensive computation based on the pre and post
27th February 2015 interest rates has already been preparedby a keen
analyst who had shared it with a few national newspapers in late April.
That computation had estimated the loss to the government arising from
the additional interest payments in relation to the bills and bonds issued
after 27th February 2015, on the premise that the interest rates had been
artificially raised after that date. That computation had been based on
officially reported data and a reasonable and logical hypothesis, and is
therefore worthy of being used as a guideline. Therefore, the methodology
applied in that computation has been followed and applied to the issue of
subsequent T-bills and bonds as well in order topreparea complete
statement up to 15th June 2015. That up-to-date computation now reveals
theastonishing result that the extra commitment for the government as a
result of the increase in the interest rate has now reached a staggering Rs.
55 billion!(Table 2)
The loss to the public due to the unnecessary and unwarranted increase in
interest rates

In every economy, the government securities interest rates set the riskfree yield rate benchmark for all other market instruments. It also provides
guidance for the pricing of the entire range of financial instruments from
over-night bank deposit rates to ten-year prime corporate rates to even
20-year housing loan facility rates to ordinary citizens! As a result of the
Bondscam, it is now evident that every borrower has had to suffer a
premium on the interest payable, since the interest rate equilibrium that
prevailed at that time was greatly disturbed, leading to higher costs and
greater risk, both individually and as a society. The cumulative impact and
effect of such extra interest to be paid by the publicis undoubtedly
colossal, and would be in the range of tens of billions of Rupees, although
a careful study would need to be done to arrive at an accurate estimate of
such losses.
The loss to the economy due to the growing erosion of confidence as a
result of the scandal
It is an indisputable fact that, if the risk-free bench mark yield curve is
artificially corrupted or manipulated, or does not reflect the underlying
macro- fundamentals including low inflation, it creates a huge asymmetry
in the functioning of financial markets. There will also be a crowding-out
effect in the government budget financing, while the loanable funds
available for the private sector will be drained. In such circumstances, the
private sector, which is expected to make an annual investment of at least
25% of the GDP to generate an annual real GDP growth of around 7.5%,
would not be able to do so, and such a situation would eventually have a
highly negative impact on employment and other macro-economic
variables as well. The resultant instability will lead to loss of confidence
amongst investors, who then either postpone their investment decisions,
or demand higher premia for their investments.
Ominous signs of such outcomesare nowvisible inthe Sri Lankan economy,
with the Sri Lankan Rupee being under pressure, exporters showing
reluctance to repatriate their sales proceeds, foreign reserves falling, and a
discernable trend of foreign investors leaving the Government Securities
Market and the Colombo Stock Exchange. These qualitative and
quantitative losses in the economy are significant and far reaching, and a
considerable part of that instability could be attributed to the Bondscam
and massive quantum of negative publicity that hadarisen as a result of
the scam.
Shedding light

It is hoped that the above narrative and analysis would help shed greater
light on this meticulously-planned, multi-faceted and far-reaching
scam,which has badly damaged the credibility of the Sri Lankan economy
and inflicted the biggest-ever loss. Armed with such information, it is also
hoped that those in authority and all other stakeholders would now more
confidently raise their voices as a consequence of having better
understooditsdifferent aspects, components and repercussions.
Posted by Thavam