ECONOMYNEXT – Sri Lanka’s government should sell long duration floating rate bonds, perhaps even perpetuals in the style of UK Consols as part of efforts to manage the its debt better and make use of domestic capital.
After an external debt crisis hits a country with monetary instability and bad central bank, the International Monetary Fund encourages countries to issue longer term debt, or to restructure debt to reduce the roll-over or the gross financing need.
READ MORE ABOUT UK CONSOLS HERE:
After Sri Lanka’s first default, maturities of pension fund debt were extended and there and the politicians in charge of the stabilization crisis faced political flack.
GFN going up is a result of lost confidence from earlier bad monetary policy
In a currency crisis, very few people want to buy long term bonds and would prefer to be in Treasury bills.
An increase in GFN is a normal market reaction to uncertainty about the future, after rate cuts with printed money trigger a currency crisis. This has been seen in all currency crises in Sri Lanka, whether 2001 or 2022.
However, the benefit is not one-sided. It also gives a benefit to the issuer
Short term maturity also leads to a quick fall in interest costs, if there is more short-term debt after things come back to normal and the exchange rate stabilizes.
Reducing GFN and restructuring are just firefighting after-effects of monetary instability and activist central banking.
Reducing GFN is fine as a crisis tackling tool, but in the long term, prudent and consistent monetary policy, where the central bank is not a party to depreciation, social unrest and default is the answer.
Killing Two Birds with One Stone
But leaving that aside, one way to achieve both objectives is to issue floating rate notes. In the US there are also inflation protected bonds.
READ MORE ABOUT TIPS – Treasury Inflation Protected Securities
Sri Lanka should have a mix of bonds.
In the UK, there were perpetual government debt called Consols, (consolidated annuities or consolidated stock) which were issued as far back at 1700s.
These were fixed rate instruments at a time when permanent inflation and depreciation and wildly fluctuating interest rates from ‘macro-economic policy’ was still a thing of the future.
There may be little demand for it initially but some banks may be willing to go for such instruments.
Sri Lanka should issue some volume of floating rate bonds, either perpetuals or 20 or 30 year bonds but with floating rates eventually.
Undated securities may be a far cry at the moment, but very small amounts could possibly be sold as banks may be able to substitute them for their Treasury bill holdings and match them with deposits.
But a start can be made with 5-year bonds or shorter ones.
In theory floating rate bonds would trade at par or close to par.
Sooner Sri Lanka gets used to such instruments the better.
It will make banks safer if the central bank triggers crises in the future under a different leadership, and reduce costs for the government if the agency maintains monetary stability, or the parliament forces it to do so.
The central banks bond portfolio
The central bank also has step down bonds. Compared to floating rate notes, which can trade close to par, step down securities have greater marked-to-market risks.
It may be a good idea to convert the step-down securities with Treasury approval to floating rate instruments which will make them more attractive to buyers. There may be some legal changes required.
Going from fixed rate long term bonds to step down securities is a big jump.
While the central bank has made provisions in its books for the bonds, they may not be truly liquid instruments for banks to hold.
Converting them to floating rates could make them trade close to par or at par and increase their appeal.
The central bank ended up with the step down securities, not due violating a bills only policy, but a deliberate action to stop a broader default of rupee securities which will kill confidence in government rupee securities.
Though the intensions good, they are not liquid and shows why central bank before inflation and social unrest, confined themselves to bills which could easily mature and expire.
It must be remembered that ‘central bank independence’ that the Fed achieved in 1951 under the Treasury Fed Accord was not the discretion to act outside the parliamentary control of public finances as it is now interpreted as by the IMF and others, but a return to a ‘bills only’ policy and drop yield curve targeting (buying bonds) like a hot potato.
All of these principles have now been violated with the Fed and other central banks buying long dated securities.
Dollar Consols
Sri Lanka can also sell some long term floating rate dollar bonds to the banking system to settle one of the early maturing sovereign bonds and take some of the dollars that foreign currency banking units are flushed with.
It is prudent that some of it is invested abroad, but banks should not be forced to buy increasingly risky foreign investments by giving no other domestic alternatives, signs of which are emerging now.
But such an issue has to be properly marketed and only used to settle a sovereign bond, which has peculiar risks to countries like Sri Lanka due to the lack of liquidity for such instruments.
A syndicated loan may be better option for several reasons, which are too complicated to go into now.
Economic Shocks from Discretion
Given Sri Lanka’s monetary instability, and a number of other risks, including credit risk and the political beliefs, which adds to volatile policy, very long-term rates could be in the double digits until the central bank’s operating framework improves and long-term monetary stability is reached.
That is because the current operating framework gives too much discretion to the central bank and little or no parliamentary oversight.
In any case Sri Lanka has a 5 to 7 percent inflation target, which means even the current short- term rates are out of line with the central bank’s inflation target.
The Federal Reserve, set up as a largely unaccountable state bank, compared private central banks which were under control of parliament and the laws of nature through the gold standard, was the primary culprit for the present-day troubles.
This is why gold is now 3,200 dollars an ounce from 20 dollars when the Federal Reserve was set up and food prices are volatile and vast populations are driven to starvation in a matter of months.
In countries like Sri Lanka and forex shortages and exchange controls have become endemic, in a mute testimony to the flaws in the operating framework of the central bank where the people and the country as a whole has to suffer with lost economic freedoms.
In Sri Lanka the central bank can print any amount of money through open market operation as it wishes. That it cannot print money is an absolute lie was proved in the last quarter of 2024.
Open market operations is the most dangerous tool that was responsible for the Great Depression, the Housing bubble and the current troubles that the US and Western Europe is facing.
As a result of ‘central bank independence’ individual governors and their beliefs can deliver severe shocks to the economy. This has been seen in the US in particular.
The Lesson from Consols
The UK’s Consols themselves are an example. The 4 percent yield on UK Consols, which had a fixed coupon was widely bought by investors throughout the gold standard. The early ones were sold at rates of 3 percent or below.
Interest rates in the UK did not go much above 5 percent in most credit crises that the UK experienced before Bank of England was nationalized and deliberate ‘macroeconomic policy’ was pursued generating instability without war.
In 2014 after low rates amid an abundant reserve regime and the ‘single policy rate’ the UK redeemed the 4.0 percent bonds which dated back from the 18th century.
“…[T]he Treasury is confident that it can deliver value for money to current and future tax payers by refinancing this borrowing now at lower rates than the 4% it is currently paying,” HM Treasury said in famous last words.
“The government is only able to do this today because interest rates are lower today, thanks to the confidence in the plan that the government has put in place to cut borrowing and create a resilient economy.”
The original consols were sold with coupons as low as 2.5 percent and 2.75 percent.
In 2013 the Bank of England shifted to ‘flexible inflation targeting’ the deadliest monetary regime since the 1960s full employment policies where quantitative easing – a crisis response to boost asset prices – became normal policy.
QE open market operations are not designed to actually build houses, but pushes up house prices and other assets. As a result rents are sky high in most countries.
Now as chickens come home to roost under the single policy rate and repeated bouts of stimulus, the UK is paying 4.5 percent on just 10-year bonds.
Given the abundant reserve regime, and the single policy rate, the supreme irony is that some of the Consols that were redeemed in the quantity easing period were originally sold in connection with the South Sea bubble which collapsed about 10 years later.
In part the the UK was able to redeem the bonds because the Bank of England and other central banks were violating the ‘bills only’ policy.
The story of the single policy rate and abundant reserve regime and central banks which violate the ‘bills only’ policy to buy long term bonds is not yet over.
The Bank of England’s challenge now is not a ‘bill mountain’ like in Thatcher’s Britain. Given today’s context that was a good problem to have.
There is a frightening deterioration of monetary knowledge worldwide, in the US in particular, though Europe is slowly waking up.
This column warned last April the US was heading for a debt crisis. Some of what was mentioned then has now started to happen. To head off a default there has to be knowledge and smart action. At the moment, there is neither.
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With bad money, the government’s hands are also tied as happens in wartime.
Sri Lanka will also have to brace for the impact. (Colombo/May19/2025)