ECONOMYNEXT – Finance Minister Mangala Samaraweera started a price formula in 2018 May just as fuel price started to spike, but the Ceylon Petroleum Corporation (CPC) made a colossal loss Rs104 billion, and the rupee collapsed anyway.

According to finance ministry data, fully Rs82.5 billion of the enormous loss came from forex losses.

Is there a Nick Leeson at CPC or was it moral suasion by an outsider in the Central Bank or Treasury that led to the debacle?

Graph: Bell logo

And in the process, did he/they sabotage Mangala Samaraweera’s price formula, knowingly or unknowingly?

These are essential questions to answer since it will help avert future balance of payments crises and losses at state enterprises.

Debacle

There is a trail of circumstantial evidence about the debacle.

According to the Finance Ministry, CPC product sales by volume was virtually flat, growing just 0.6 percent to 5,624 million litres in 2018 from 5,591 million litres in 2017.

But, helped by the price formula, revenues jumped by Rs76.9 billion rupees to Rs535.2 billion rupees in 2018 from Rs458.2 billion rupees a year earlier.

Cost of sales grew by Rs105 billion from Rs418.9 billion to Rs523.9 billion rupees.

Graph: Unhedged-od

Note very carefully, CPC recorded a gross profit. This may have been helped by tax offsets also, but that is not an issue.

The entire deterioration in the gross profits was only Rs28 billion.

Other costs, including depreciation, was only Rs32.5 billion. Amazingly sales and distribution costs were down to Rs14.4 billion from Rs15.4 billion, despite all the supposed inefficiencies and overstaffing of CPC.

Profit before forex losses, including depreciation according to these numbers, reversed from Rs8.2 billion in 2017 to Rs21.3 billion loss in 2018.

This is a reversal of 29 billion rupees or only a little over the 28 billion rupee reversal seen at the gross margin level.

The finance ministry report said the operational loss was Rs22.1 billion in 2018, reversing from a profit of Rs7.7 billion in 2017.

This, in fact, is what one would expect, given the price formula.

While oil prices had gone up, according to the Treasury’s own data, they had not gone up so far to generate such colossal losses, over and above the price formula.

Graph:Oil Price

Yet there was an Rs82.7 billion loss from currency depreciation coming from dollar borrowings.

If the above gross margins are accurate, only the cash losses before depreciation, which is about 22 billion rupees should have been covered by bank borrowings. Yet the debt to banks rose from Rs338.2 billion to Rs562.4 billion, which is an enormous Rs224.2 billion rupee increase.

Cover Up

There are other clues. The government’s contingent liabilities from government guarantees rose from Rs652.2 billion to Rs828 billion.

Notes elsewhere show that that there are massive ‘Cover Up’  (whatever that means) loans to the CPC from state banks.

In 2018, a ‘Cover Up’ loan from People’s Bank jumped to US $900 million. There was also a US $700 million loan from Bank of Ceylon. There was also a $200 million balance already drawn by 2017 as well as an Rs67 billion drawdown from People’s Bank shown in 2017.

What precisely a ‘Cover Up’ loan is, will be interesting to find out.

Where did the money go?

It does not seem to have gone to the Ceylon Electricity Board as is the usual case in the previous balance of payments crises. According to CEB accounts in the finance ministry report, total outstanding to the CPC and Independent Power Producers were down to Rs71.6 billion by end 2018 from Rs72 billion in 2017.

The CEB’s own borrowings from banks had gone up from Rs24 billion to Rs67 billion with an operating loss of Rs30 billion. This type of increase in credit would usually be expected when a company runs losses.

CPC Mystery

So then why did borrowings at CPC go up by Rs224 billion? Was it SriLankan Airlines?  According to earlier reports, SriLankan is charged penalty interest; therefore, CPC can well borrow in rupees with the penalty interest.

There is no requirement to borrow dollars and run an unhedged forex loss.

One reason could be that the CPC, in fact, had rupee cashflows, and rupee deposits in banks, which it was not using to buy dollars and settle import bills. Another reason could be that it was funding other government customers, like the military or government departments.

If the second is true, then the budget deficit is understated. If the first is true, it is a significant governance failure both at the CPC and in macro-economic management.

Was the CPC being forced to borrow dollars by the Central Bank or Treasury due to some false Mercantilist belief that if the SOE borrowed dollars, it would help the exchange rate?

In March 2019, accounts of state banks like People’s Bank and Bank of Ceylon dollar loans have fallen. Borrowings from customers have also fallen. But wherever the cash went, it effectively sabotaged the price formula.

Why a price formula?

The reason analysts, including this columnist, has pushed for a price formula is not to raise the price and discourage consumption and ‘save foreign exchange’. While market pricing fuel and electricity definitely make users energy efficient, it is a gradual process, since energy demand is generally inelastic.

The reason market pricing is needed is to balance the external and domestic demand through a process similar to Ricardian equivalence.

When a user buys oil at market prices, he has to curtail the purchase of another good, which will reduce imports. When energy is market priced, there may not be much reduction in oil imports, but non-oil imports have to fall when customers choose oil over other types of consumption.

Individuals are well-qualified to decide what is ‘essential and non-essential’. There is no need for bureaucrats in the Treasury or central bank to decided what is ‘non-essential’.

This is why in 2015, despite the fall in oil prices, imports did not come down and help the ‘balance of payments’ as Mercantilist, including the International Monetary Fund said. When retail oil prices are cut, people will consume more non-oil imports.

That itself should not cause the rupee to fall since the increase in non-oil imports would be balanced by the fall in the oil bill.

The reason the rupee fell was that new money was printed by the central bank by releasing liquidity tied up in term repo deals and giving resources to give unsustainable credit, which was not backed up by deposits.

Extending the argument further, anyone can see that a person faced with rising oil prices, to keep up his previous level of consumption has to cut is savings or dip into his earlier bank deposits.

Either way, the total resources available in the banking sector for new credit would reduce. To keep the same level of credit as before, banks have to raise new deposits – or discourage our man from withdrawing his deposit – for which a rise in interest rates is required.

Therefore it can be seen that even if CPC did not have a price formula, and it ran a loss and funded that from bank credit, as long as the central bank did not control rates and discouraged banks from raising additional deposits the rupee will not fall and the external current account would not shoot up suddenly.

Sabotaging the Price Formula

On the other hand, if the CPC borrowed dollars to pay import bills and deposited the cash inflows from customers in state banks in repos or other deposits, the entire benefit of a price formula would be lost, and it would be effectively sabotaged.

The banks would lend the money in repos or deposits to other customers instead, who will pay their import bills before the CPC. Non-oil imports will not fall despite the price formula. The external current account deficit will shoot up by the amount of new dollar credit the CPC took to delay the payment of import bills.

If the currency is under pressure and the central bank continues to print money after selling dollars, the rupee will fall. CPC or any other importer for that matter will then pay the import bill, after the rupee had fallen, realizing a massive loss.

In the meantime, any remaining dollar debt will be an unrealized loss in the books of the importer. It will be translated into a cash loss when it tries to repay the loan. If there is no cash, the importer or CPC will then be forced to convert the import bill loan to a term loan, because there is no cash to cover the forex loss.

In any case, the external current account of the country will shoot up by the amount of the dollar borrowings of the importer.

In a past balance of payments crisis, the CPC ran its working capital with a loan from Iran. The external current account would then shoot up by that amount.

Central bankers and other bureaucrats then blame the current account for macro-economic instability, when in fact it is the dollar inflow from credit that made the external current account expand.

This is the problem with Mercantilism. Classical economists from Ricardo to Hayek to Mises understood both credit and trade.

Adam Smith also tilted towards the anti-bullionists and the ‘banking school’ type of debate. Mainly he argued that bills discounting did not lead to a permanent expansion of reserve money, which was more nuanced. This is a bit like the central bank saying term reverse repo injections are better than direct interventions in the Treasuries market. But that is a separate story.

But modern-day Neo-Mercantilists cannot make the connection between credit and international trade at all.

This may be because their understanding of credit and monetary systems is weak and modern universities see no reason to teach monetary economics. It is a well-known fact that Keynes did not get the connection between money, credit and trade either (The Keynes–Ohlin controversy).

If the government runs a budget deficit financed by foreign borrowings, there will also be a trade deficit. If private firms borrow abroad or get foreign direct investment, there will be a trade deficit and current account deficit. If the CPC borrows 900 million dollars, also there will be an expansion in the external current account by that amount.

Questions to Answer

There are important questions to answer.

CPC only has little dollar revenues from aviation fuel sales and the like, which far outstrips in rupee sales and dollar imports. Why is the CPC which has rupee revenues allowed to have such colossal unhedged dollar borrowings?

There was a time when even private firms which did not have dollar revenues were not given clearance to borrow dollars. Not that it is the business of government to tell what risks private firms should assume, but CPC is definitely a government business.

Any errors fall on the heads of the ordinary people who have to bear the losses.

Why does the CPC Board of Directors allow it?

Is it because of some Mercantilist pressure from Central Bank or Treasury bureaucrats who mistakenly believe that the ‘Oil Bill’ is the reason for the rupee to fall?

Or did someone in the CPC itself borrow dollars hoping that the rupee will fall later? But can a CPC official run an open position of that nature?

It is relevant to ask the pithy Sinhala question. ‘Kawda mewwater waga kiyanne?’ (Who is accountable for this?).

But it is even more critical to make sure that such debacles do not happen in the future.

Either CPC needs better risk management or people in decision-making positions should learn economics instead of making decisions based on Mercantilist false doctrine.

It is well known that Sri Lanka’s bureaucrats have peculiar Mercantilist fears about the ‘oil bill’.

They undoubtedly think in some voodoo Mercantilist way that oil is different from some other imports. Many believe inflation is caused by diesel; therefore, money is printed to keep diesel prices down.

In the times of classical economists, gold was a hot button. In the early 19th century in the time of Ricardo, it was corn imports.

Today it is oil and cars. Gold remains a hot button as import taxes by both the Central Bank of Sri Lanka and Reserve Bank of India show.

Gold taxes are an overt sign of a Mercantilist fog enveloping the macro-economic policy framework.

Mercantilism may be fine for debating at the coffee table or economic forums. But ignoring economics and acting on Mercantilist doctrine has disastrous consequences for the people.

Private companies can make any number of mistakes.

It is not like Nick Leeson at Bearings where some wealthy shareholders sell the company for one dollar.

Errors of the state and officials are paid for by ordinary people, who will have to pocket it out in taxes.

This column is based on ‘The Price Signal by Bellwether‘ published in the July 2019 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.