Central Bank sets its record straight on hedging

The attention of the Central Bank of Sri Lanka (CBSL) has been drawn to recent media reports wherein it had been claimed that the government was trying to protect certain officials including the Central Bank Governor, Ajith Nivard Cabraal. While, as a policy, the CBSL does not respond to individual statements, since the tone and nature of some of these remarks and analysis appears to impute impropriety of the conduct of the Governor and certain other officials of the CBSL and thereby to tarnish the image and credibility of the institution, the Central Bank wishes to issue this statement in order to set the record right.

(1) Towards the latter part of 2006, oil prices started to increase sharply and that resulted in Sri Lanka’s expenditure on petroleum imports to rise from US dollars 837 million in 2003 to an estimated US dollars 2.1 billion in 2006. The following Table that was prepared around end 2006, sets out this position:

The predictions in the market towards end 2006 were also that the oil prices would increase further in 2007 and beyond in view of the high demand from the China and India and this development was expected to exert severe pressure on Sri Lanka’s balance of payments and the exchange rate.

(2) Accordingly, in order that the Ceylon Petroleum Corporation (CPC) would be able to withstand the impending worldwide oil shock, the CBSL was of the view that it would be useful to introduce hedging techniques within the CPC. In line with such view and the CBSL’s role as the Economic Advisor to the Government, on 6th September 2006, the Governor of the CBSL made a presentation that was prepared by the Economic Research Department of the CBSL, to the Cabinet of Ministers on the subject ‘Maintaining Stability in a Volatile Global Oil Market’, in which the importance of hedging to achieve stability in oil prices was highlighted. In that presentation, the CBSL explained to the Cabinet, that there are financial instruments to reduce exposure to risk from volatile commodity prices and that in order to do so, the CPC may need to enter into forward agreements for future oil imports with reputed banks or pay a premium so that agreed prices could be held firm. Two possible hedging instruments were also specifically proposed in that presentation, as follows:

(a) Crude Oil Cap

CPC sets the maximum price: i.e., the Cap. If the market price rises above the Cap, the hedging bank will pay the difference to the CPC. If the market price drops below the Cap, CPC is free to buy from the open market. As consideration, CPC needs to pay a premium for each barrel.

(b) Zero-cost Collar

CPC sets the maximum price: i.e. the Higher Collar. In response, the bank sets the floor price: Lower Collar. If the market price is above the higher collar price, the hedging bank will pay the CPC, the difference between the higher collar price and the market price. If the market price is below the lower collar price, the CPC will pay the hedging Bank, the difference between the lower collar price and the market price. No premium is involved.

(3) Consequent on the presentation, the Cabinet of Ministers decided that a committee comprising officials from the CBSL, Bank of Ceylon, People’s Bank, Ministry of Finance & Planning, Ministry of Petroleum and Petroleum Resources Development and CPC be appointed to study the subject further, and to present a report to the Cabinet. This committee, duly studied the subject and presented a report to the Secretary to the Ministry of Finance & Planning on 16th November, 2006.

(4) By early January 2007, since hedging had still not commenced and Sri Lanka’s vulnerability was increasing, the Governor sent a letter to the Chairman of the CPC, dated 10th January 2007, in which he stated as follows:

“As you are aware, the Central Bank of Sri Lanka was instrumental in promoting hedging as a means of purchasing petroleum and made a presentation to His Excellency the President and the Cabinet of Ministers on 6th September 2006. The Central Bank has also made available to the CPC, certain technical details and options for hedging. However, we note that the CPC has so far not been able to enter into any form of hedging or other acceptable financing arrangement to ensure that Sri Lanka’s petroleum bill will be at manageable levels in 2007. As you may agree, petroleum prices have now reduced to about US $ 55 per barrel, this may appear to be the opportune time to enter into suitable arrangements to hedge at least a part of our country’s total requirements. Hence, in the interest of the national economy, I would urge you to take the necessary steps to ensure that expenditure on fuel prices will not cause undesirable effects on the macro-economy in 2007.”

Such advice to the country’s largest single importer was obviously, sensible and timely. Accordingly, it is clear that the advice cannot, in any way, be considered imprudent or irresponsible. In fact, the events of 2007 and 2008 clearly indicate how vital and important this advice had been.

In response, the Chairman of the CPC, on 11th January 2007, assured the CBSL that the CPC is “in the process of working out necessary details in getting the hedging process expedited as quickly as possible”. To such letter, the Governor of the Central Bank responded on 16th January 2007 by stating that the CBSL is pleased that the CPC is “working out the necessary details in relation to implementing the hedging processes as quickly as possible”. Such a response was made in the context that, at that time in January 2007, it was highly desirable and opportune for Sri Lanka to make use of the depressed prices to commence hedging.

(5) On 13th January 2007, the Hon Minister of Petroleum and Petroleum Resources Development presented a Cabinet Memorandum setting out the recommendations of the study group seeking the approval of the Cabinet. Subsequently, approval was duly granted by the Cabinet for the following actions:

(i) CPC to hedge purchase of petroleum products, both crude oil and refined products in the international market.

(ii) Use Zero-Cost Collar as the hedging instrument with the upper bound based on market developments.

(iii) Commence hedging with smaller quantities for a shorter period and gradually increase the quantity and the duration.

(iv) Grant authority to the CPC to call for quotations for oil hedging, decide on future prices and purchase hedging instruments from reputed banks.

(v) Grant authority to CPC to change instruments based on the developments in the market.

(6) Once the Cabinet of Ministers approved the concept of hedging and permitted the CPC to commence hedging operations, the role of the CBSL in this exercise which it initiated as the economic advisor to the Government, was completed. Accordingly, the CBSL was not, and indeed did not need to be, involved in the hedging transactions of the CPC. In this context, it should also be noted that the CBSL regularly provides policy advice to the government and government institutions by way of observations to Cabinet Memoranda and the September 15th Report prior to the announcement of the Budget. Upon the acceptance or otherwise of such policy advice, the responsibility of either implementing or not implementing such proposals, lies entirely with the implementing agency. At the same time, in order to create greater awareness among the public, the CBSL published a Technical Box Article in its Annual Report of 2006, issued on 31st March 2007, on the topic: Hedging Oil Imports against Price Volatility. (Vide Page 47 of the Central Bank Annual Report 2006). In this article, the CBSL discussed the many aspects of hedging as well as the generally available instruments worldwide, to undertake hedging. The following extract from the Box Article confirms that hedging, if properly carried out, could still be a useful instrument to mitigate the impact of adverse price fluctuations: “Like an insurance policy, hedging is used to protect against unexpected negative events. This does not prevent the negative event from occurring, but if it does happen and if it is properly hedged, the impact of the event is reduced. Thus, the hedging is not aimed at generating profits, but mainly protecting from losses that could arise from adverse price fluctuations.”

(7) From the above actions of the CBSL, it would be clear that the Governor and other officials of the CBSL have carried out their duties and responsibilities in a prudent and professional manner, in complete contrast to the allegations and insinuations made.

(8) After the recent developments in relation to hedging were known, the CBSL has already taken several steps in the effective fulfillment of its role as the regulator of the commercial banks. In fact, the CBSL had commenced its examinations into the banks’ roles in hedging transactions in early November 2008, well before any petition or plaint had been filed in Courts. Nevertheless, at present, since hedging related issues are the subject matter of judicial proceedings before the Supreme Court, the CBSL would refrain from making any comments in relation to its current investigations.

In conclusion, the CBSL wishes to assure the public that it would discharge its duties in accordance with the law and the directions that have been issued to the Monetary Board by the Supreme Court, in a professional, fair and forthright manner.