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Sri Lanka's profits and losses; a super profit making central bank is not good news
19 Apr, 2010 06:19:10
By W A Wijewardena
Apr 19, 2010 (LBO) - Two news items hit the headlines of media simultaneously last week. Both relate to the year 2009 and are sourced to the Central Bank Annual Report for the year.
One is the news on the key state enterprises making colossal losses. The other is the news on Central Bank’s making unprecedented profits. State enterprises making losses is bad news. But, Central Bank’s making super profits, though it appears to be a good performance, is very bad news.

Public Enterprises Making Losses

The five big loss makers which were once categorised as the ‘biggest monsters’ by the Minister of Finance, plus the Sri Lankan Airlines, have made operating losses amounting to whopping Rs. 48.6 billion in 2009. The detailed distribution is alarming: Postal Rs 2.4 billion, CEB Rs 7.4 billion, CPC Rs 12.3 billion, SLTB including the government subsidy, Rs 9.3 billion, Railways Rs 4.8 billion and Sri Lankan Airline Rs 12.2 billion.

In addition, Mihin Air, government’s pet budget airline, has made an operating loss of Rs 930 million on top of its previous losses amounting to Rs 3 billion absorbed by the government earlier. These numbers just present the difference between the current revenue and current expenditure of these enterprises before charging depreciation and writing off the unrecoverable debts. Hence, the net losses made by them must be much more than the amounts reported in the Central Bank Annual Report, but it will take some time for those numbers to surface because of the delay in publishing the audited final accounts.

Losses Have to be Funded by the Public

There is nothing new about public enterprises making losses and getting away with such losses with total impunity.

In fact, they have been continuously in losses and those losses have been funded by the public through subsidies: for instance, according to the data provided by the Central Bank Annual Report, the two transport enterprises, Railways and SLTB, have made operating losses year after year since 2000 amassing cumulative losses of Rs 31.3 billion and Rs 30.3 billion, respectively, by end - 2009. If they were two private sector firms, they would have by now been bankrupt and forced to close their business.

However, all these enterprises have been able to continue their business with subsidies given by the government and loans raised from banks, especially from the two state banks, on the strength of government guarantees. Either way, it is the public who have to bear the burden of such losses eventually. Subsidies are directly funded out of the current tax revenue; defaulted loans are settled by the Treasury, again by issuing Treasury bonds making it a liability of future tax payers. Hence, the public enterprises making losses is undoubtedly ‘bad news’.

Central Banks’ making Super - Profits

If making profits by a public enterprise is good news, making super profits must be extra good news. Then, how can one argue that central banks’ making super profits is very bad news?

The answer is given by the Central Bank itself as a Management Statement attached to its final accounts.

It says that the Central Bank’s core objectives are the attainment of economic and price stability and financial system stability and the Bank’s performance should be assessed on the basis of its attainment of these two goals and ‘not necessarily its profitability per se’. The adoption of a profitability related approach by the Central Bank ‘could result in the Bank pursuing profits while compromising its core objectives, since it has the unique ability to create its own profits through its monetary policy activities which could influence interest rates and exchange rates’.

Many who read the Central Bank’s final accounts tend to miss this clarification. What it says is that a central bank is different from other organisations and in a position to create its own profits, but at the expense of the objective of maintaining an inflation free world.

Central Banks can earn domestic incomes only by creating new money

This could be illustrated as follows. The only power which a central bank has got is to print money. It has to print money when it lends to government and commercial banks and when it buys foreign exchange from the market. Lending will enable the central bank to earn interest incomes in rupee terms; investment of foreign exchange will earn it returns in foreign currency terms.

So, both will increase the bank’s profit levels. But when it prints money more than what the public wants, there will be surplus money in their hands and, therefore, in order to reduce such balances to desired optimal levels, they will use that money on goods and services. If the supply of money is faster than the supply of goods and services which is the usual case, the excess demand for goods and services will put pressure on the prices to rise.

When this happens continuously over a period of time, it leads to inflation. By printing money, a central bank can make profits, but such money will invariably bring about inflation too.

Thus, a central bank can make any amount of profits by printing money, but such profits are made by sacrificing its price stability objective.

Bank’s Financial Performance in 2009

Central Bank’s financial statements show that it has made a thumping net profit of Rs 33.7 billion in 2009. In comparison, in 2008, it made a net loss of Rs 5 billion. Hence, one may draw the conclusion that it has converted itself from losses to profits and its financial performance has been superior to any of the other public enterprises. Both conclusions are erroneous.

The principal source of the losses of the Bank in 2008 was the decline in the Rupee value of its foreign exchange reserves, Rs 23 billion in all, due to the appreciation of the Rupee against the Sterling Pound and the Euro. Since the Bank can influence the direction of the exchange rate, it could have avoided these losses by allowing the rate to depreciate adequately. But the Bank’s exchange rate strategy did not allow it to depreciate the currency and therefore, instead of showing profits in its financial statements, it chose to show losses in 2008.

The source of profits of 2009 was completely different. The Bank made a moderate income of Rs 4.6 billion out of its investment of foreign assets. This was enhanced by a book entry of Rs 8.8 billion representing a gain emanating from the revaluation of the foreign assets at the year - end exchange rates. But the super profits of the Bank came from its domestic activities, namely, its lending to the government. The domestic interest income so earned amounted to unprecedented Rs 28.1 billion as against Rs 7 billion earned in 2008.

Since the interest rates on Government Treasury bills declined substantially during the year, from around 19 percent at the beginning to 9 percent at the end, and stood on average at around 13 percent per annum, to earn such an income, the Bank would have lent the Government a total volume of Rs 216 billion during the year. This is purely new money created by the Bank and according to economists’ parlance, high powered money that leads to multiple money creation by the country’s banking system in the years to come.

When one considers the inflationary impact which such high powered money brings on the economy, Central Bank’s making super profits is not good news.

John Exter’s Wisdom

John Exter who drafted the Central Bank’s law wanted to prevent these profits from being used by the Government because it will create a new cycle of monetary expansion. Thus, he made any profit transfer to the government conditional upon the Bank’s first meeting various other priorities such as building up of capital and absorbing previous losses.

If the Bank desires to make any profit transfer, it should do so, according to the law, after meeting these priorities and having properly apprised the Minister of Finance of the consequences of such a profit transfer. In that manner, unlike the other public organisations, the Government does not get the first priority for the profits of the Central Bank.

However, the Government has the right to claim the profits made by the Central Bank on its investment of foreign assets, since the Bank does so on behalf of the Government. The underlying reasoning is that, if the Central Bank does not manage the country’s foreign reserves, the Government will have to do it by itself and it can then appropriate such incomes for its budgetary expenses.

According to Central Bank Annual Report, in 2009, the Government had anticipated a profit transfer of Rs 8 billion from the Central Bank. But the actual amount paid in the year has been Rs 20 billion and this appears to be an advance extended by the Central Bank to the Government to meet its urgent financial commitments pending the finalisation of its final accounts in February 2010. This profit transfer is very much higher than the earning of Rs 4.6 billion which the Bank made out of its foreign investments and which the Government can legitimately claim as its due from the Bank.

A Central Bank should not Make Losses either

Thus, making super profits by a central bank is very bad news. This does not mean that making losses by a central bank is tolerable and acceptable. Such losses eventually have to be funded by the tax payers just like any other public organisation. Hence, making both losses and making super profits by a central bank are not good news at all.

The writer is a retired deputy governor of the Central Bank of Sri Lanka. To read previous columns in the series go to the WatchTower section on the main navigation panel or click on the links below.

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20. sameerat May 01
When an accountant heads a Central Bank this is what the result...showing a surplus to the stake holders..John Exter has mistaken to make it mandatory to appoint economists to head SL Central Bank..
19. aj Apr 26
I think Mr W has answered the question. In fact in the current cycle also he has advocated that the central bank to refrain from keeping the system loose.

Once the demon is unleashed it is three times as difficult to put back. Read the the last WatchTower on 'Should the CB continue with no policy action.'

The central bank also made similar noises in the last monetary policy report.

18. Educated Ignoramus Apr 25
I find it difficult to follow all this, but, as an unsophisticated and ordinary citizen, I'm grateful to all those who have commented; one wishes that those in charge of the Economy of Sri Lanka will study all this. Thank you Mr Wijewardena.
17. Tharu22 Apr 22
Mr. Wijewardene,
I don't think you answered my question. But that's ok
16. W.A Wijewardena Apr 22
To Tharu22,
A common feature of action taken by central banks is that they are too late and too short.

Too late in the sense that action is taken exante and not expost. When a central bank decides to tighten monetary policy after it has seen a surge in building inflationary pressures in the economy, it is too late and ordinary public has already lost a significant part of their wealth, savers their savings, exporters their export earnings, immigrants the real value of the remittances they have sent to their relatives etc. Too short in the sense that the required adjustment would have been much larger than what has been adopted.

15. W.A Wijewardena Apr 21
The amendment made to MLA in 2002 took the responsibility for maintaining fixed or pegged exchange rates away from the shoulders of the Central Bank.

The rationale was that CB could stabilise only one price, i.e., general price level, and not a whole gamut of other prices in the economy, viz, interest rate and the exchange rate. The last two are simply the outcomes arising from the first one.

The pegged exchange rate which is currently being pursued is an aberration of the objectives and the scope of monetary policy. The authorities seem to believe that, with the powers they have, they could control all variables in the economy.

This they could do only when God is on their side. But, when God turns against them, at that point, they will find that they have lost control of everything they had tried to control previously.

14. Tharu22 Apr 21
Mr. Wijewardene,
Again, I do not see you commenting on what they "should have done". Speaking of intended and unintended consequences of actions taken is one matter, but it is far more difficult to come up with concrete alternatives
13. fuss-budget Apr 21
Mr Wijewardene
Hasn't another (illegal) mandate of defending a peg crept into the whole kettle of fish of late? Correct me if I am wrong but preserving the external value of the rupee was intentionally and explicitly dropped from Sri Lanka's monetary law long ago.

So peg defence (which led to liquidity shortages etc) could perhaps be easily proved to be illegal in courts if someone wishes to do so.

12. W.A Wijewardena Apr 21
To Tharu22,
Unfortunately for CBSL, it has to strive to realise two core objectives, namely, economic and price stability and financial system stability, which are contradictory to each other.

For instance, if the Bank is to achieve financial system stability at a time when the banking system is in utter distress, it has to provide liquidity funding to banks which will act counter to its pursuing economic and price stability objective. Hence, the Bank is expected to strike a balance between the two by using its superior judgmental power and give priority to what it considers as the public enemy number one at the time.

Remember that some have argued that the proliferation of high interest offering spurious savings institutions and the public's attraction to them had been prompted by the Bank's refusal to maintain a real positive rate interest in 2006 to 2009 amidst the surging inflation in the country. The Seylan Bank fiasco is only one aspect of this whole story.

The CB should nevertheless be given credit for handling the fiasco without necessarily harming its price stability objective and limiting its accommodation of Seylan Bank through BOC to the required minimum.

Yet, the full cost was passed onto the private sector through aggressive OMO which resulted in creating a liquidity shortage and difficulty in raising credit from the system.

11. Tharu22 Apr 21
Mr. Wijewardene,
In your view what is that Central Bank "should" have done especially during the 1st 2 quarters of last year? I hear many commentators critical of what they are doing (or what they did) but not many who suggest a better alternative
10. fuss-budget Apr 20
Very true
The model behind central banks is profit through inflation. Sources are;

a) central bank credit to government (money created out of nothing like a godly miracle or counterfeit scam)

b) money created for the private sector through discount window and open market operations.

c) later on lender of last resort bailout facilities.The exception is the Fed, which was created primarily as a bailout agency by the big US banking families who did not want to be left with the baby when banks that took excessive risks and created too much credit suffered runs.

d) the fourth was one was currency depreciation - if the central bank has assets in gold or foreign currency. However they are always depleted when it happens. To be fair however Bank of England for example has tended to resist devaluation when in private hands. Of course it created other problems. Only after government take-over did they resort to debauching the currency extensively.

Without exception all central banks have created big messes but were subject to increasing parliamentary regulation when it became apparent that they are dangerous. However some of these regulations have actually backfired, for example Peel Act 1844 because more powers were given accidentally.

No central bank however has done more damage to the world generally than the Fed. It created the Great Depression and the Great Recession.

The Bank of England was started by a group of entrepreneurs led by William Patterson. He soon left the bank to found the Royal Bank of Scotland.

John Law was another Scotsman who failed to start paper money in England but went to France. He destroyed the country and had to flee later.

Johan Palmstruch was the man behind the Swedish central bank. He was condemned to death but pardoned. Many of the people behind France's second state paper money scheme were guillotined to death.

Bernanke meanwhile is getting accolades for 'saving' the world. That shows the power of present day mercantilism.

At a very basic level, a broken deflationary bubble (great depression, great recession,) is an averted hyperflation episode. So you can say thank god (or the CB governor concerned) for small mercies, let the central bank make extraordinary profits because at least we avoided a hyperinflationary episode. It is certainly the lesser of two evils.

In a hyperinflationary episode a central bank will make massive losses as it tries to sterilize at a negative carry its increasingly valueless liabilities and lose all its assets and destroy itself as well as the economic geographical region covered by its paper monopoly. This goes on until people shift to a different central bank through dollarization. The economic collapse involved in such situations is much much worse.

That is central banking in a nutshell.

9. W.A Wijewardena Apr 20
To Tharu22,
Thanks for the intervention.
The obligation of CB is not to the government, but to the public.
When the community handed over the money printing power to the state, there was doubt whether the state would use that power responsibly. In fact, some of the earlier experiences revealed that it did not. For instance, in Sweden, the king used that power to wage war with its neighbours and the result was that the money held by the public declined in value thereby abrogating the promise made by the king that he will see to the stability of its value. This led to the creation of an independent Sverigis Riks Bank there.

So the central banks' prime duty is to preserve the value of the money they have printed on behalf of the governments and not be a party to its erosion.

My worry is that the central banks have failed in that duty. The other day, I met a government pensioner who had retired in mid 1980s as a head of an important department. At the time he retired, he said that he got a handsome pension which was sufficient for him to keep himself and his wife.

He says his pension today is some 26000 rupees and it is barely enough for him to met the monthly medical bills of himself and his wife.

Who is to be blamed for the broken promise?

8. Tharu22 Apr 20
To Mr. Wijewardene,
It is clear that each action by the CB has consequences; some intended some not. However, when the CB makes decisions it makes them in a dynamic world with many factors at play. Some of them may not be purely economic, but never the less they are not unimportant.

Considering the global economic climate, as well as domestic security, political, and economic conditions I think its fair to say that CB has done a decent job given the tools at its disposal.

Keeping everything else constant, it is easy to criticize policies such as inflationary money printing, but those ceteris paribus conditions do not hold in the real world. Given the external and internal conditions last year, we could have ended up in a much worse situation and since we did not I think its fair to give some credit to CB.

As for CCPI, I knew that they were not computed by the CB, but was unaware that the calculations take place in such a secretive manner. If so, it is a very dangerous policy, not only because it misleads the public, but more importantly it can lead to erroneous policy decisions. Thank you for illuminating us on this.

7. Perara Apr 19
This is a very good analysis. I think analyses such as this should appear in Sinhalese news papers too for the general public to know and so I request the author to publish this article in Sinhala as well.
6. W.A Wijewardena Apr 19
To Tharu22,
The Central Bank in its sincerity, humbleness and modesty, does not take pride in the profits it has made. That is why it has made a clarification to its financial statements. As you say, profits are simply the outcome of its operations. It is not the profits which are bad, but the operations which have led to super profits.

Those operations involving the creation of high powered money will lead to monetary expansion which the Bank has to reverse through tight monetary policy, in the current case, by resorting to aggressive OMO. This is actually what the CB did as is evident from its final balance sheet. But, such OMO reduced the domestic liquidity for the private sector making it difficult for them to acquire their requirements. Hence, it is akin to a tax being imposed on the private sector operations. Thus, by accommodating the government, private sector has been penalised.

For your information, CCPI is not computed by the CB, but by the government's Department of Census and Statistics. Since Census operates in a 'black box' environment, people outside have suspicions about the output they produce. In the modern world, these are tackled by full disclosure, transparency, generating public debate on changes being proposed and subscribing to international best practices like the IMF's General Data Dissemination System (GDDS) or at a higher level, its Special Data Dissemination system (SGGD). Sri Lanka has to go a long way with regard to establishing such good practices.

Those of us inside Sri Lanka do not understand the value of these good practices. But, I have been questioned at length by people outside and people who matter. I did not have satisfactory explanation to those questions.

Anyway, your interest in these matters is encouraging.

5. Tharu22 Apr 19
First of all, what is "bad" is a centra bank in "pursuit" of super profits. This is not same as a central bank "making" a super profit in a given year since the profit can arise purely due to technical aspects of the pursued monetary strategies.

And for Saman,
The fact that inflation index has been changed does not indicate it understates inlation. As a matter of fact every responsible Central Bank changes the composition index time to time in order to reflect the changes in consumption pattern. If you're to question this you need to show how the recent changes lead to systematic understatement. I have not seen anybody doing this

4. Saman Apr 19
Your comment is valid if we accept the figures published. The problem is that the Central Bank growth figures are overestimated due to the inflation figure being underestimated.

The inflation index has been readjusted a number of times to show a lower rate of inflation.

Therefore when the factor for inflation is removed from the nominal growth figure to arrive at the real growth, real growth is overstated.

3. fuss-budget Apr 19
Neither the US nor the Sri Lankan government did much to increase growth. After a bubble bursts ultimately ordinary people in productive sectors have to pick themselves up and work even harder. The so-called 'jobless growth' is also a facet of this.

In fact some economists have shown a lot of evidence to indicate that government interference may actually delay the recovery and prevent the steepness of a v shaped recovery once it takes place. In that case all this is a Keynesian fallacy.

Even FDR's famous 'New Deal' has been blamed for creating uncertainty and blunting a recovery.

There is no substitute for hard work by normal people in productive sectors. That will become more evident as the debts piled up by interventionists (you have show that something is being done otherwise politically you will be perceived as a lame duck) weigh on the future.

2. Bandara Gajanayake from USA Apr 19
During the era of great economic downturn, Sri Lankan government able to maintain slower economic growth. While the USA showed negative Balance of Payment for last few years. The losses experienced in certain sectors in typical service oriented sectors like railway in Sri Lanka is common as those sectors are not profit oriented.

At the same time it is not a strange thing to see central bank showing some extra ordinary profits compare to other years as the country is experiencing a completely different political, social and economic environment. I see this trend is not bad and it is a good sign of countries positive economic growth.

1. fuss-budget Apr 19
For decades Sri Lankan citizens have been complacent to let politicians of all hues drive the agenda and literally scam them and spread poverty by expanding the state and getting priviledges for themselves.

It is good that the process is now being questioned withe evidence.

The Federal Reserve after almost destroying the world by creating a big bubble and breaking it is estimated to have made a profit of 50 billion dollars in 2009, the highest in its history.