It has already been over a month since the completion of Domestic Debt Optimisation (DDO), where 12 Treasury bonds owned by the Employees’ Provident Fund (EPF) were exchanged for bonds with extended maturities and lower yields. Nevertheless, concerned parties have raised questions on the real impact on the EPF and why the banking sector was left out of the restructuring.
Central Bank of Sri Lanka (CBSL) Governor Dr. Nandalal Weerasinghe said that the main reason for the banks to be excluded was to maintain financial stability and to avoid adding more burdens to the heavily-taxed industry.
Although many parties requested that the EPF be left untouched, only a few managed to provide proper alternatives to Domestic Debt Restructuring (DDR). Many attributed the lack of alternatives to the lack of crucial data on the bonds and EPF made available to the public in the pre-DDO period.
The Sunday Morning was able to gain exclusive access to the majority of this crucial data that still remains unavailable to the public despite the DDO being completed, which it will analyse in this article. In addition, The Sunday Morning also spoke to experts who offered new alternatives and calculated the loss to the EPF.
‘Renegotiate FD rates’
Speaking to The Sunday Morning, independent Economist Dhanusha Pathirana said that the argument put forward by the CBSL – that the banking sector would collapse if domestic debt restructuring were to be extended to the banking sector – was false.
“It will have an impact if they go for a haircut,” he said, adding that the Government had opted for an extension of maturities and slashing yields on superannuation funds.
According to him, reducing yields of Treasury bonds held by the banking sector will impact liquidity and reduce cash inflows, especially given that banks are also paying extremely high interest rates on fixed deposits issued last year and early this year.
He noted that the banks were paying the interest income of Treasury bonds directly to Fixed Deposit (FD) holders and the portion which remained in the banks was being taxed on a progressive basis.
“It is perfectly conducible and practical to renegotiate the high interest rates offered to FDs in the banking system to the current market level,” he said, adding that it would balance the cash inflow and outflow, eliminating the impact on bank liquidity.
Pathirana said that the banks could negotiate the rates given to the top 5% of depositors – most of whom had received special rates above the rates advertised last year and early this year – in order to offset the reduction in yields.
He said that the special rates given to these top depositors had resulted in banks being unable to reduce lending rates to the level to which policy rates had dropped, even when Treasury bill and bond rates had fallen.
“This will in fact benefit the banks as well, because it will improve their future lending,” he added.
He pointed out that banks had relied on Government securities to provide for Government debt and had recorded huge profits at a time when credit to the private sector had declined by about 8% between June 2022 and August 2023.
However, he said that there would be liquidity issues for banks if the maturity periods were also extended. In that event, banks would have to do the same to FDs to offset the cash flow and timing issues, he added.
Further, Pathirana said that rates of the top deposits would not have to be overly reduced in order to offset the reduction in yields, because among the assets of the banking sector only 15-20% were Treasury bonds and slashing their yields by 50% would bring rates down to the current market level of around 14-15%.
“That doesn’t mean the entire asset base is affected; it will only affect 15-20% of the assets in the banking system, while FDs account for about 60-70% of the total liabilities of the banks,” he said.
In order to offset the cash inflow reduction from assets, he said that the banks did not have to reduce interest rates in the same way when it came to liabilities.
Four cases against DDR still pending before SC
Pathirana said that there were four cases still pending against the DDR in the Supreme Court and the court had only approved the 30% tax on the superannuation funds proposed by the DDR process.
He said that the Supreme Court had dismissed the case against the taxation on the superannuation funds citing that it did not understand it and that the petitioners had not offered a clear picture or an alternate solution, resulting in the court deciding in favour of the Government.
According to the Supreme Court determination, there is institutional incapacity in the courts to reassess or re-appraise the policy decisions in the event evidence to the contrary is unavailable.
Pathirana said that the other four cases were based on information which only came after the CBSL had already decided on the deal, which he said was completely against the law. “They should have given the details of the bond portfolio they are going to exchange along with the yields before the DDR,” he added.
Calculating loss to EPF from DDO
In calculating the impact of the DDO on the EPF, Pathirana’s calculation has taken the yields of the new bond portfolio of the EPF that was exchanged to calculate the weighted average yield of the portfolio.
According to the new bond portfolio, there will be one coupon payment in November 2023, as coupon payments come semi-annually in the months of May and November.
Therefore, he said that until the 2026 May coupon payment, the CBSL would be paying 12% to the entire bond portfolio which was exchanged, while the November coupon payment would be 9%.
The average annual rate for 2026 is 10.5% and from 2027 to 2037 (2038 will not be taken as the last bond is maturing in March 2038, so there will be no coupon payment) it will be 9% annually.
Based on this, since the principal value of all 12 bonds is equal with each at Rs. 267,038.5 million, adding up all the rates from 2023 up to 2037 and dividing by the number of years gives the weighted average yield of 9.7% (before 14% gross taxation and reduction of management cost of EPF); once those are deducted, the weighted average yield comes down to 7.6%.
When the same calculations are applied to the pre-DDR bonds portfolio, the weighted average yield as of October 2023 is 13.6% and it reduces to 10.9%, after deducting 14% gross tax and 0.7% management costs, as per the rate announced by the Superintendent of the EPF at the Public Finance Committee meeting on 7 September.
The weighted average yield changes when bonds mature and exit the portfolio. To be comparable, it should be calculated for the pre-DDR portfolio annually, up to 2037, by excluding the maturing bonds. The annual average of this is 14.3% before taxes and expenses.
“Even without calculating the compounded cash flow losses and the terminal value loss on the difference in yields, we can immediately see that the 9.7% average yield of the DDR portfolio is 32.2% below the 14.3% return of the pre-DDR portfolio,” Pathirana said.
According to him, to calculate the lost cash flows from slashed interest rates and compound it to arrive at the total nominal cash flow loss due to DDR and the loss ratio, the difference in weighted returns to the DDR portfolio of 12 bonds before tax and expenses are applied.
Pathirana said that this showed a total cash flow loss of Rs. 1,266.4 billion before compounding up to 2037. When compounded by 9.7% annually (the DDR yield which the CBSL agreed to pay), the total nominal cash flow loss increases to Rs. 2,933.8 billion, deriving a loss ratio of 50.01% before the terminal value loss of Rs. 2.1 trillion is added
He added that the CBSL’s calculation claiming a 4% opportunity loss to EPF by opting for DDR was completely incorrect as the CBSL had taken the cash flows of these portfolios separately, where the difference between the pre-DDR and post-DDR cash flow of the bond portfolio showed a 4% loss.
He said that it was similar to extending the maturity of a five-year Rs. 1,000 bond with a 10% annual interest, which would give the bondholder Rs. 500 at the end of the maturity of 10 years while reducing the rate by 5% and still saying that the holder was not at a loss as he would still get the Rs. 500.
He noted that the relative gains and losses of two portfolios with different maturity profiles were calculated by using the yields of the two portfolios.
‘Liquidity not an issue for banks’
Speaking to The Sunday Morning, former Chairman of the Ceylon Chamber of Commerce and good governance activist Chandra Jayaratne said that although banks were charged about 48% in taxes (30% Corporate Tax plus 18% VAT on financial services), the taxes were in turn earned back from customers while income tax was paid only on net gains like every other corporate in the country.
“If you take the net adjustment banks can get from the DDR and assume that 25% of their bond portfolio goes away, then the amount of net tax they are paying is not equal to 48% anyway,” he said.
He said that the banks, primary dealers, and high-net-worth individuals had made significant profits from Government securities, while bonds had been discounted in the secondary market at 1-2% higher than the market rates while they had been purchased at 30% plus.
Jayaratne said that the banks also had a realisable gain at any moment from the bond portfolio to address any liquidity issue, as they could sell the bonds in the secondary market with an immediate capital gain.
He added that since the market rates had come down from 30% to 15-16%, the banks did not need to wait until bonds matured, as they could discount it at 17% in the secondary market when the market rate was 16% and immediately receive a capital gain of 30% minus 17% .
Moreover, he said that he was one of the four petitioners whose cases were still pending in the Supreme Court against the DDR, where he was trying to show anecdotal evidence by taking four individuals.
“I have taken a few examples such as a factory machine worker lady whose salary is Rs. 45,000 a month and therefore not liable to tax, an account clerk whose salary is Rs. 70,000 a month who is also not liable to be taxed, an accountant who is getting Rs. 120,000 a month who is eligible for the marginal rate of tax which is 6%, and a general manager who is getting about Rs. 300,000 a month and is subject to a 18% tax rate,” he said.
Jayaratne said that out of these people, the factory lady and the accounts clerk had no other savings for retirement other than their EPF balance.
He added that the four people had invested in the EPF and did not have the benefit of selling their stake and being solvent and would only get their money at the end of the period.
Further, on the 9% rate of return on EPF bonds, he said that 9% may look like a fixed return today, but going by interest history in the past 25 years, it would fluctuate, as inflation was badly managed and would never be the 5% which the CBSL Governor had discussed.
“EPF members will only get 9%, while, if inflation is high, other people will get more,” he added.
‘Renegotiating FD rates impractical’
Speaking to The Sunday Morning, a senior banker said renegotiating FD rates of customers did not usually happen in the banking sector anywhere in the world. “I don’t think it is possible (to reduce rates) for deposits they have already put in,” the banker said.
The official also said that if rates of deposits were going to be slashed, customers would not deposit their money in the banks and bigger deposit holders would probably take deposits away, not just from the banks but from the country and park them in another country.
According to the banker, this will not only put the banking sector at risk, but the outflow of capital will be a problem for the country.
Moreover, the banker said that although such treatments were good arguments, implementing them would not be straightforward but fairly complicated and that any such treatment should be equal for every customer.
Crucial data on EPF impact
The Sunday Morning received exclusive access to the report presented by the CBSL to the Committee on Public Finance (COPF) last month based on a request, regarding the impacts of the DDO on the EPF.
As per the report, as of end 2022, the face value Treasury bond portfolio of the EPF was Rs. 3.17 trillion, while the purchase value was Rs. 3.06 trillion and the market value was Rs. 1.91 trillion.
The weighted average yield of the bond portfolio of the EPF as of 30 May 2023 was 12.78% on a pre-tax basis and 10.99% on an after-tax basis, assuming a tax rate of 14% per annum. Treasury bonds purchased before 1 April 2018 which are still in the portfolio were already subjected to a 10% Withholding Tax.
The report also showed the Net Present Value (NPV) impact on the EPF bond portfolio on pre-tax and post-tax scenarios of the DDO process. It showed that the pre-tax NPV discounted at market yield rates as of 29 August 2023 at 0% tax reduction was Rs. 349.76 billion on accepting the DDO and Rs. 126.12 billion on not accepting the DDO.
Also, the post-tax NPV discounted at market yield rates as of 29 August 2023 at 14% tax on accepting the DDO reduction was Rs. 620.98 billion, while at a 30% tax rate when not accepting the DDO, the reduction would only be Rs. 598.93 billion.
This indicates that opting not to go through with the DDO has a NPV gain of Rs. 20 billion over choosing the DDO. It is noted that the NPV does not include reinvestment of cash flows and that the NPV is highly sensitive to the yield rates used to discount.
The above NPV computation by the CBSL is done on the assumption that the weighted average maturity period of the portfolios not accepting the DDO is 5.92 years while it is 9.56 years when accepting the DDO.
Also, only the cash flows arising from the Treasury bond portfolio as of 14 September 2023 have been considered as applicable for the two options, irrespective of reinvestments and the amortised cost identified as the settlement data has been considered as the purchase cost of the T-bond portfolio.
The mid yield published by the Public Debt Department (PDD) of the Central Bank in its Daily Summary Report as of 29 August 2023 has been used to compute the NPV while interpolating the mid yields for the maturities for which the PDD mid quotes are not available.
The report also states that the taxable income of Treasury bonds held by superannuation funds which participated (14%) and did not participate (30%) will remain unchanged until 2045. However, in the statement released by the CBSL on the decision of the EPF participation in the DDO, it has been assumed that these tax rates will remain unchanged until 2038.