By W A Wijewardena –
Two policies relating to lending
Recently, there were two policy pronouncements relating to lending, one already implemented by the Central Bank and the other being proposed for implementation by the SLPP presidential hopeful, Gotabaya Rajapaksa, that if he is elected to presidency. Rajapaksa was the first to make this offer, but as past experiences have shown, it is not unusual if the other candidates would follow him with better offers. When coaxed by a questioner in the audience at the recent meeting with the business community that he should also offer loan waivers, DNF candidate Sajith Premadasa offered to support the farming community by offering input subsidies like free fertiliser to all the farmers, a similar undertaking involving taxpayers’ money.
Central Bank’s requests going unheeded by commercial banks
The Central Bank, obviously outraged by the stubbornness of commercial banks when it asked them to cut lending rates in line with its relaxing monetary policy, has now done what it can do under the law. Earlier in April, it requested commercial banks and non-bank financial institutions which are mainly made up of finance companies to cut deposit rates to be in line with the Central Bank’s borrowing rate to accommodate excess liquidity of commercial banks, known as Standing Deposit Facility Rate or SDFR, and one year Treasury bill rate.
The objective was to reduce the cost of funds of these financial institutions so that they could in turn bring down the lending rates, especially those applicable to the Small and Medium Enterprises or SMEs. Since this measure did not bring in the expected results on the lending rates, later in July, the Bank provided a further boost to this by getting non-bank financial institutions to cut deposit rates again. The Bank once again requested these lending institutions to cut lending rates to facilitate economic growth. But the lending institutions were still stubborn.
Making a final assault on stubborn commercial banks
Then, the Central Bank in September made the final assault, by ordering commercial banks to cut their lending rates by at least 2%, by using the powers it possessed under the Monetary Law Act or MLA. The Bank may have felt that this is an unwarranted order which has a place only when the country is faced with a national emergency. Hence, it has promised to review it in March 2020. However, by way of justification, the Bank tagged this order as a way to ensure that its monetary policy measures aiming at making credit cheaper for borrowers are more effectively implemented through the financial system.
This is the first time, in its whole history, that the Central Bank has used its powers to order commercial banks to cut lending rates. In the past, the Bank had got commercial banks to cut interest rates not by ordering them, but by using other tactics. For instance, it got the Ministry of Finance to direct the two State banks to cut lending rates, so that other banks too had no option but to follow suit. This was criticised by many as an ‘arm-twisting method’, converting the Bank’s normal ‘moral suasion’ to ‘immoral suasion’. As such, the present management in the Ministry of Finance or the Central Bank would have chosen not to tarnish its image by resorting to such arm-twisting methods.
Gotabaya Rajapaksa’s promise to farmers
The SLPP presidential candidate, Gotabaya Rajapaksa, addressing the nation from the farmer country centred on the historic city of Anuradhapura, promised that if he is elected to power, he would take the farmers out of indebtedness, by writing off farmer loans granted by banks. Rajapaksa did not give details of how it would be implemented, but going by the past practices of politicians, the promise can be construed as directing banks to write off the existing bank loans given to farmers for agricultural purposes, mainly for cultivating paddy. This was not the first time politicians had promised to write off farmer loans.
In 1994, Chandrika Bandaranaike Kumaratunga too made such a promise when she sought election to the presidency. But, what was delivered was not an across-the-board loan waiver. It was applicable to loans in default, provided the defaulter agreed to repay 25% of the amount in default. Thus, without offering a general loan write-off, the Ministry of Finance and the Central Bank managed to maintain credit discipline among the farming community.
In all other elections, it was an open secret that the local party stalwarts of the two major political parties made this promise to farmers when they visited them to canvass their votes. Hence, promises to write off farmer loans are a common tactic used by Sri Lankan politicians to woo the farmer community to their side.
The same is practiced in both India and Bangladesh at all elections. Drawing on the experiences of India, Raghuram Rajan, Ex-Governor of the Reserve Bank of India, warned in his contribution in the collection of policy articles in the new agenda for India’s economic reforms titled ‘What the Economy Needs Now’, edited by the 2019 Economics Nobel Laureate Abhijit Banerjee and others, that it would make farmers worse off rather than help them. This has been a warning to Narendra Modi, who just started what the analysts have termed Modi 2.0 government after the recent electoral victory. It can be taken as a warning to Sri Lankan politicians too.
Lowering inflation when growth is slowing down
Both the Central Bank and Rajapaksa, and also the other politicians who might follow him, may have gone for these two options with good intentions. The Central Bank has been able to keep inflation below 5% in most the years since 2009. This is in fact maintaining virtual price stability by the Central Bank, since an annual inflation rate of 4-5% is considered a rate that would not adversely affect people’s decisions on earning, consumption, saving or investment.
However, this price stability is irrelevant if the economy does not wake up from the low growth slumber which it had been happily devouring in the last 6-year period. The best projections made for the next 4 years too show that growth will be only marginally better than the low rate it had recorded in the past. As a result, to boost the economy, the Central Bank has been relaxing monetary policy, by way of reducing interest rates and releasing a significant part of the money belonging to commercial banks that had been kept with it as compulsory deposits, known as statutory reserves. This would increase the supply of money to the market, and in any other market where supply has exceeded the demand, the price would have fallen.
Cheap money to promote investments
Similarly, the expectation of the Central Bank had been that these monetary policy relaxations should lead to a downward adjustment of the whole interest rate structure in the country. Such a low interest rate regime would ease the working capital constraints of businesses on the one hand, and encourage them to go for permanent investments, on the other.
In economic terms, the resolution of the working capital problem of businesses will enable the economy to produce and maintain its current production level, which in turn will help it to use resources unimpeded and employment undiminished. The permanent investments are to help the economy to use more resources, employ more people, and produce more. It will ensure that the economy will accelerate to a higher growth path, the need of the day.
Hence, if interest rates do not fall in line with Central Bank’s relaxed monetary policy measures, the expectation of moving from the current low growth to high growth will simply be a non-event. It is an outcome which the Central Bank cannot afford to have at this juncture of prolonged low growth. The politicians may be quick to blame the Central Bank, as it has always happened in the past, for the mess in the economy. Thus, the bewildered Central Bank has resorted to a policy measure which it had not considered desirable in the past.
A Leviathan at work
This problem is not a problem of the Central Bank alone. It is a problem which the whole nation faces today. Hence, it is a problem which all the presidential hopefuls should endeavour to find a solution. However, both the Central Bank and presidential hopefuls have touched the problem from its tail, whereas the issue is like a sea monster, similar to the proverbial Leviathan in the Biblical tales, which is immersed deeply in the water and ready to attack its prey without warning. The reality is that SMEs are indebted not to the formal banking institutions, but to the informal money lenders who operate as solo lenders or organised fake microfinance institutions.
Three case studies
I have collected the story of three such small entrepreneurs who have ventured into income-earning self-employed projects. One is a fishmonger, another is a tailor, and the third is a vegetable and fruit vendor. All operate from permanent places of businesses located along a major highway.
The woes of a fishmonger
The fishmonger tells me that he buys his fish from the Peliyagoda Wholesale Fish Market by paying ready cash. His daily purchase on average is about Rs 200,000. But his main customers are hospitals and restaurants, which do not pay cash immediately. His normal credit sale cycle is about one month. Sometimes, they give him post-dated cheques which he sells to cheque buyers at a discount of 6%. Even then, his cash flow is in deficit, and he has to finance it by borrowing. He categorically tells me that formal commercial banks, both state and privately owned, do not entertain his requests for temporary overdrafts. He had approached one such private sector bank and the bank manager has been unresponsive to his demand. Then, one day he had been visited by a young man on a motor bicycle, and briefed of the possibility of getting an instant loan repayable within 100 days. He had been told that if he borrowed Rs 100,000, he should pay interest at Rs 10,000 per month, which is worked out to be 10% per month or 120% per annum. Since he needed money very badly and the formal commercial banks were not of help, he had borrowed Rs 500,000 from the informal money lender. He had not signed any document or loan agreement, but spoken to the informal money lender on the telephone and agreed to the terms and conditions.
The young man on the motorbike had immediately delivered cash to his fish stall. Thereafter, every month, he had visited him at the fish stall to collect the interest. For two months, he had paid interest with great difficulty. But it became a real problem after the infamous April 21 bomb explosions, when the restaurants which had purchased fish from him started to cut the daily purchases and default the payments. Their explanation was that customers who had earlier frequented the restaurants in the night had dwindled due to curfews and unsettled situation in the country. He had to default the payments, and only then had he found the real taste of his borrowing at exorbitant interest rates.
The young man on the motorbike was insisting that he should pay or go for a new loan with stricter conditions now, namely, a loan for 75 days at 12% per month. He did not have a choice, says the fishmonger, but to accept the new conditions which were more stringent than the previous loan. Probably, if he defaults again, the period would further be reduced and interest rate be increased. Like the sovereign Government of Sri Lanka, the fishmonger is deeply indebted and has to service his loan by getting further indebted. Since he does not earn a return of 120% and above per annum, it is unlikely that he would be out of debt. He is already caught in the debt trap.
A tailor cutting family welfare to service informal loans
The story of the tailor is similar to the fishmonger. He had purchased clothes on one month credit and tailored school uniforms for students. Typically, in previous years, he did not have difficulty in selling those school uniforms to students for cash before the school season starts in January. However, this year, he could not dispose of the stock because the demand had fallen. Apparently, the parents had their own financial problems that prevented them from supplying new school uniforms to their children. Faced with the problem of paying back his creditors, he had approached a commercial bank for a bridging line of credit, but to no avail.
Then, he had been helped only by the friendly-looking young man who came on a motorbike. Within hours, the tailor could raise a loan of Rs 400,000 at 10% per month repayable within 100 days. But, from the very first month onward, he ran into difficulty in paying interest because he did not have a sufficient surplus after meeting the rent, utility fees, and family expenses. He cut the family expenses, but still could not have a sufficient surplus to pay as agreed interest payments. Finally, he had to go for another loan with stricter conditions as in the previous case, and now he is deeply indebted.
A vegetable vendor getting into debt
The vendor of vegetables and fruits had a daily turnover of about Rs 100,000, but due to his wife delivering a baby, his monthly income was not sufficient to run the business. He had not tried a bank and straightaway had agreed to the conditions laid down by the informal money lender, and borrowed Rs 200,000 for 100 days at 10% per month. Since his margins are very narrow, he cannot earn enough surplus to pay interest on the loan. He fears that he has to recycle the loan once he has to return the principal amount after 100 days. Knowingly or unknowingly, he has been into debt now.
Ignored SME borrowers
The behaviour of these borrowers is not different from that of the Sri Lanka Government which has borrowed partly for consumption and partly for investment, mostly in unproductive projects. Since the economic growth has not been adequate for it to earn sufficient income, every year, it had to borrow more to repay the maturing loans, and pay interest on the existing debt stock. Fortunately, it could still access global financial markets to do so. However, those borrowers in the SME sector cannot reach a commercial bank and raise a bridging loan to refinance what they have borrowed from informal money lenders. Their choice is to abandon business, and it is happening now.
Two policies that have gone wrong
Hence, the Central Bank’s well-intentioned measure of fixing a ceiling on lending rates of commercial banks and finance companies is not of use to many SME businesses. Similarly, the promise to write off farmer loans by Rajapaksa, and other presidential hopefuls who would follow him, will not help the economy at large. What is needed is for the formal banking institutions to change their lending behaviour, and emulate informal money lenders when they meet the financial requirements of SME borrowers. Since possibly they could lend below 10% per month, their loan schemes will not drag the borrowers to eternal indebtedness, as is the case with informal money lenders.
Perhaps Rajapaksa and other presidential hopefuls will take this into account when they prepare their election manifestos in the days to come.
*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at email@example.com