By Chandra Jayaratne –

Open letter to business leaders

It will be wise and timely if business leaders (and also depositors) start paying attention to the emerging potential risks across the banking sector. They should collectively engage in critical risk reviews, supported by economists, banking and finance experts and business sector leaders.

The Economic Intelligence Units of the chambers should initiate the process with a position paper to be reviewed by the chamber committees. These reviews should lead to the identification of medium term (one to three year) risks of banks and the finance sector and the likely consequential impact on the business sector and stakeholders of banks, especially depositors.
The risk mitigation strategies, strategic collective action, advocacy and communication strategies should also be developed and implemented as appropriate, in the interest of the nation, the business sector and the people.

Commercial banks and even leasing companies have initiated processes towards borrowing in foreign currency. Some of these borrowings are with State facilitation and the currency risks are swapped to the account of the State. Others may be borrowing in foreign currency, with the currency risk entirely to the account of the bank concerned.

The lack of transparency and clarity surrounding these transactions increases the associated risks. Some of these borrowings are significant in comparison with the balance sheet size of the banks concerned. Even smaller banks and leasing companies appear to have begun exercising the option of lower cost borrowings, with currency risks spared or even carrying the currency risks to its account.

Aggressive marketing initiatives

Customers and prospects are targeted with aggressive marketing initiatives by local finance companies. Banks in competition also focus their attention on depositors, offering high rates of interest, gifts, incentives and lotteries. Tele-marketing, SMS marketing, e-marketing and one-on-one canvassed marketing initiatives supplement attractive media advertising. It is clear that banks and finance houses are aggressively competing for a share of the consumer savings.

These foreign and local borrowings and local deposit mobilisation initiatives are in the backdrop of an environment where there are definite signs of changes in key economic indicators. The changing trends in future growth prospects, investments, growth of export earnings, private sector credit growth, borrowings by key State institutions, tax revenue to GDP, level of the national debt, the component and structure of the foreign debt and fiscal deficit are all indicative of weakening signs. These indicators should generate ‘amber’ lights to flash on the ‘risk assessment’ screens in front of business leaders and even depositors.

Increasing and significant levels of profits of banks, levels of foreign inflows to the stock market, the pickup of stock market indices, increasing foreign reserves, stable exchange rates and relatively lower inflation rates, all flashed with a fanfare by the monetary authorities, must be cheered only with eyes open and following diligent and wide scanning and examining all relevant economic indicators.

IMF warning

“Sri Lanka should be careful about mounting external liabilities and reserve adequacy, with national debt already on the ‘high side’ at over 80% of Gross Domestic Product,” the International Monetary Fund (IMF) said in February 2013.

The IMF drawing attention to contingent liabilities highlighted that “about 47% of that debt was foreign or denominated in foreign currency; up from 44% a year earlier and about 12% of the rupee denominated debt is also held by foreign investors”.

The IMF went on further to state: “Sri Lanka spending agencies including road and urban development agencies have started to borrow on their own account outside the budget, which tend to understate the overall budget deficit and the national debt” and “about 3.8% of GDP is sovereign guarantees issued by the Finance Ministry to various lenders, including foreign banks which have given loans to loss making entities such as SriLankan Airlines”.

These comments were made in the context of the appropriation bill increasing the 4.5% of GDP ceiling on sovereign guarantees set by a Fiscal Responsibility Act. It is in this context that the IMF stressed the need to pay attention to contingent liabilities and highlighted that “if there are either sovereign guarantees or exchange rate guarantees that are being considered that also has to be taken into consideration when one thinks about debt sustainability,” pointing out that Sri Lanka’s Central Bank had several hundred million US dollars worth of foreign exchange swaps, which are exchange rate guarantees with various lenders who were encouraged to borrow abroad”.

“Sri Lanka has to watch inflation, bank credit, tax revenues, keep monetary policy tight and avoid guaranteeing bank forex borrowings and instead create an environment for foreign direct investments,” the International Monetary Fund said in May 2013.

The IMF Director cautioned against easing of monetary policy in the near term, and said the exchange rate should not be defended aggressively. “Exchange rate flexibility should be maintained to cushion external shocks, while deeper markets and a gradual move toward a flexible inflation targeting regime would strengthen inflation control,” the IMF’s Executive Directors said in a public information notice.
It is thus timely that the risk assessments led by business leaders examine whether the contrary policy regimes now enforced by the monetary authorities will enhance the medium term risks.

Sri Lanka was warned against encouraging excessive foreign borrowings and was encouraged to boost Foreign Direct Investments. Attempts to give forex guarantees to banks to borrow abroad may hurt monetary stability and economic stability in the future, IMF Directors said.

“Directors noted the long-term deterioration of the export-to-GDP ratio and growing reliance on debt for current account deficit financing.” Instead of more debt, IMF Directors called on authorities for “further improvements in the business climate to attract Foreign Direct Investment,” adding that “Sri Lanka has resumed expropriating private property and there are increasing concerns over deteriorating rule of law”.

Export earnings and borrowings

Sri Lanka’s earnings from exports declined by 2.8%, year-on-year, in March 2013 whilst the overall export earnings in the first quarter from January to March declined by 8.1% to US$ 2.36 billion. The business leaders should also assess whether the expenditure on imports which declined by 16.0% to US$ 4.49 billion creating a trade deficit of US$ 2.13 billion in the first quarter 2013 is in any way related to a significant lowering of the import of investment goods, which imports act as drivers of future growth.

Business leaders must take it upon themselves to assess the specific drivers weakening export earning and assess the consequential risks to the economy in the medium term, especially if any external issues endanger expanding in the medium term, inward worker remittances above US$ 7.5 billion estimated for 2013.

The 2013 Budget gave incentives for listed corporate bond issues and permitted DFCC and NDB, each to raise forex borrowing over 10 years up to US$ 250 million, with the Government underwriting the exchange risks and providing domestic bonds to invest the funds interim. However it appears that these bond issues have not yet come in to fruition. The detailed terms of offer of the currency hedge and associated terms and conditions are not clear to the stakeholders of banks, who require such information for risk assessment. It is most likely that other commercial banks will also put pressure on the authorities to extend similar facilities to them.

The budget also allowed local commercial banks to borrow up to US$ 50 million and corporate entities to borrow up to US$ 10 million, without Exchange Control approval. It is believed that these borrowings will not enjoy Government-extended currency swaps in mitigating exchange risks.
It is hoped that business leaders do not have short-term memory and will recollect the risks that crystallised in the past via foreign borrowings by corporate entities, especially by those without a natural hedge against currency fluctuations. Business leaders must worry significantly if local commercial banks borrow in foreign currency not against FCBU linked banking transactions, but for on lending in rupees to entities with local trade operations.  If the local banks borrow significant sums at a time when local private sector credit growth is restricted and there is heavy liquidity in the market, will it result in a lowering of credit evaluations and security cover and consequently leads to potential higher levels of nonperforming loans, risking the stability of banks?

State-run Bank of Ceylon sold a US$ 500 million five-year bond in April 2013, attracting two billion dollars in offers. In 2012 Bank of Ceylon sold a US$ 500 million five-year bond. The State-run National Savings Bank has retained the services of mangers to place an international bond sale of up to a billion US dollars.

Earlier this year the State-linked largest non-bank lender sold Rs. 6 billion in five-year bonds with a yearly coupon at 17%. A recent SMS offer from a State merchant bank offers depositors long-term deposits with 20% interest coupons. These reflect yet another example of finance houses forgetting negative lessons from their past.

Risks by State banks

Media reported that the Cabinet had approved a proposal by the President as Minister of Defence and Urban Development to develop the GOH as a five-star hotel at a cost of US$ 1 billion. It said the GOH and adjoining lands owned by the Police Department and the waterfront would also be developed while maintaining its heritage.

It went on to state: “The Bank of Ceylon has prepared a comprehensive redevelopment project proposal covering the above area. The project is to be implemented in three stages and the total investment would be around $ 1 billion.”

If the Bank of Ceylon is to invest long-term in this project, (whilst already having a significant portfolio of local and foreign currency transactions with State institutions whose debt service capacity without Treasury additional funding are in doubt), the question business leaders should examine are the risks carried by this State bank.

People’s Bank, already carrying a significant exposure to State institutions, appears to be committed to cover the funding needs and expanding risks of its leasing subsidiary. This subsidiary is borrowing in local and foreign currency to support expanding its lease portfolio. Media once reported that this leasing subsidiary had transacted 3,000 leases over a weekend at a special ‘Leasing Pola’ (market) in Kurunegala. Will nonperforming leases and interest rate, currency and mismatch risks come to roost in this subsidiary in the medium?

No risk review will be complete without an examination of the potential risks on banks arising from the operations of other heavily-borrowed State institutions, Ceylon Petroleum, CEB, Urban Development Authority, Road Development Authority and the combined SriLankan/Mihin Airlines.
These institutions are heavily indebted to State, local commercial and foreign banks, with some borrowings guaranteed by the Treasury and backed up by currency hedges in the Central Bank books. Here the risk profile appears to become significantly impacting on banks as the borrowing levels increase and investments made by the Urban Development, Road Development and Airlines are unlikely to release free cash flows adequate to cover debt servicing. CPC and CEB cash flows are based on politically weighted pricing formulae and the latter sensitive to available water resources for hydro power generation.

In the airline sector, the costs of modernisation of the fleet (said to involve the acquisition of nearly 25 new aircrafts in 2012 and 2013), competiveness, comparative lower operational efficiency and extra costs of operation to justify Mattala Airport will surely put these institutions into free cash flow deficit. (Whilst SriLankan is acquiring 25 new aircrafts over two years, the bigger and more network extensive American Airlines boasts in advertisements that they are acquiring one plane per week i.e. 52 per year)

External stability

Dushni Weerakoon’s article titled ‘Sri Lanka’s External Stability: Foreign Debt and Export Earnings’ must receive the careful attention of business leaders, especially:

1. Sri Lanka has been witnessing a persistent weakening of its export capacity, with the exports to GDP ratio falling to a low of 16.4% in 2012, and a declining share of the global export market. In 2012, earnings from exports contracted by 7.4%, and have continued to contract by 8.1% in the first quarter of 2013.

2. Sri Lanka’s external debt has grown at an annual average of 16.4% during 2006-12, while earnings from exports of goods and services have grown at only 8.7% during the same period.

3. The share of non-concessional and commercial borrowing rising to 50.5% of total external debt in 2012 from a share of 7.2% in 2006.

4. The imposition of an 18% ceiling on credit growth of Licensed Commercial Banks (LCBs) in 2012 was relaxed to 23%, so long as the additional funds were borrowed from overseas.

5. The uptake of foreign borrowing by State-owned banks and other private entities entail continued external sector risks for the country as a whole.

6. The most prudent strategy to insulate an economy from rising exposure to foreign debt is to ensure a healthy growth in earnings from exports of goods and services, and build-up a ‘war chest’ of non-borrowed official reserves.

It is the fervent hope that the risk review will envelop the banking and finance sector risks arising from the global and local macro economic impact, country risks, exchange rate/interest rate, mismatch and other financial risks, as well as key operations risks arising from:

1. Governance risks in the face of the State involvement in the control of banks, with stage managed board appointments made possible using the voting power of the EPF/ETF , Insurance and State Banks

2. Independence of the Board and Management being threatened leading to independent and capable directors and Senior Management exiting

3. Interference in management and state directed lending and investments and decision making controlled via non independent directors

4. Weak regulatory and oversight structures

5. Lack of independent analysts and competent media critique

Voice of business led advocacy and bold and timely strategic action can mitigate risks not only in the banking and finance sector but also across business and the nation.

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