14 July, 2020

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Sri Lanka Treasury & Central Bank Should Consider Credit Guarantees For Covid-19 Distressed Bank Loans

By the Advocata Fellows –

Liquidity injections will impact forex market and debt repayments

Even though Sri Lanka’s economy has opened up, businesses are still recovering from the dual shock of the locally imposed curfew as well as the global fallback from the coronavirus. A vast majority of Sri Lankan businesses are in need of support if they are to survive the next few months. The need of the hour is for liquidity support and enhanced access to credit. However, banks are finding this situation to be challenging. They need to be able to finance the loans that are being demanded, but they also need to have some guarantee that their loans will not go bad.

Prof. W.D. Lakshman

Will the Central Bank’s solution work?

In response to this problem the central bank has announced a subsidized credit scheme for businesses. Through this, the Central Bank will be offering a facility of Rs 150 billion to Licensed Commercial Banks (LCBs) at a concessionary rate of 1%. LCBs in turn will be required to lend to businesses at a rate of 4%. 

Put simply, the Central Bank is essentially offering commercial banks a credit line to solve their issue of a source of financing this new demand for loans.  

Assuming that the bank’s marginal cost would be around 1%, they are left with a contribution of 2% before provisioning. Lending to this segment of businesses will be risky as many of these borrowers are already leveraged, and do not have spare collateral to pledge. Under distressed economic conditions, non-performing loans could increase significantly. While a part of the non-performing loans could be partially recovered, the impairment cost or credit cost could be as high as 6%.  If the net contribution to the banks is 2% after their direct cost, a potential 6% credit cost per year would mean a pre-tax loss of 4% per year; creating the need for a credit enhancement or guarantee. 

This credit line means that the Central Bank is printing money to meet this requirement, leading to a monetary expansion. The risks of increasing money supply in the current economic context is that the subsequent pressure on the exchange rate will result in a depreciation of the currency. Looking at Sri Lanka’s import bill, 19.8% of our imports are consumption goods, and 57% of imports are intermediate goods for production. The share of investment imports is also higher than consumption goods at 23.1%. The impact of a depreciating currency will be significant on the economy’s ability to recover and grow. 

There are additional risks associated with this solution. A key problem is that while banks are receiving newly minted money from the central bank to finance the loans, the bank and the depositors have to take the credit risk on the lending. The collapse of finance companies in recent years shows what happens when deposit taking institutions take on risks that they cannot bear. Bad loans of Sri Lanka’s banks have been rising since the currency crisis in 2018, and the Easter Sunday bombings. The banks are already burdened with the credit moratorium that was also given in early 2020. In the first quarter of 2020, bad loans had risen to 5.1 percent, which is the highest since the third quarter of 2014. If banks collapse, the government may end up having to bail them out with capital injections. At the moment Sri Lanka’s banking system is fairly sound and given the indications that bad loans will rise, all efforts must be made to keep banks stable.

Source: Central Bank of Sri Lanka, Data Library

 

Further Complications

As highlighted by the former Deputy Governor of the Central Bank, and senior economist, W. A. Wijewardena, the issue with excess liquidity already in the system the problem is not about liquidity but the fear of default. According to Wijewardene, this fear of default could be tackled by a comprehensive credit guarantee scheme & smoothing out banks’ internal credit approval systems. Instead of using CRIB reports for rejecting loans, a rating system could be used to eliminate the worst ones. If treasury guarantees are available, it may not be necessary to create new money and endanger the balance payments. Banks may be willing to make loans from their own deposits if there is a guarantee. 

There is also a moral hazard associated with this decision. This crisis hit at a time where there was significant pre-existing distress in the economy, there is the possibility that this financing will be utilized to keep ‘zombie entries’ alive. Additionally, this would prevent resources from being allocated to productive and efficient firms. 

What is needed is quick support for viable companies to get their business going. Steeply subsidized credit may induce businesses to go after loans that are not needed and re-finance other loans which are at higher rates. Or whenever they have the cash the incentive will be to settle the higher cost loan than the low cost one, inviting default or delays. The artificially low rate of interest of 4 percent for working capital also may create other distortions. 

A Working Solution 

Given a challenging environment, if the authorities want to direct banks to give loans the government will have to share the risk. Ideally the credit risk should be split three ways between the government, multi-laterals and the banks to ensure that they have skin in the game. The worst case scenario would see banks with a potential zero profit from this scheme, and not the alternative of sustaining heavy losses, incentivising banks to lend.

Guarantees could also be structured to give high credit cover to smaller firms and lower amounts to large firms, as it may not be necessary to give all borrowers the same amount of credit cover. For instance, loans up to a million rupees for very small firms could be covered by a 100 percent guarantee, loans from 1 to 10 million by a 90 percent guarantee, from 10 to 20 million 75 percent and loans above 20 million to 50 percent or a similar suitable share of risk. Of course this solution is not devoid of risk. This would allow the LCBs to meet the demand for the loans, with the guarantee offered by the government.  

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Latest comments

  • 4
    0

    Incumbent president made it evasively, it is nothing but the currencies should circulate within the country. And that is it as he feels is not happening in current day actions by CB.
    _
    Is that that trivial, what happened to the bank and its actions over the years, also going back to the days of MR as minister of finance and his WANDHIB ATTAYA Ajith Kabarapaetiya as then CBG.

    If their own allies – president of SLFP of the day, former president of SIRISENA the joker of all times in srilnaken politics has the termerity to tell us all ” 2008- 2015- bond scam to have occured is over 990 billions of SL rps and sometimes it could be even beyond that” – why not today s leader who came promising and breaking all the records – not to go for FURTHER investigations on the thefts ?

    Gota will earn even our RESPECT – if he would stand against his brother’s brutal men, that did all harm to the nation by their highly corrupted attitudes. We dont care about party politics, so long Gota would deliver – as promised to the 7 millions of voters in the WAR torn country.

  • 5
    1

    Lending to businesses affected by COVID-19 without collateral is a high risk. When normal Non Performing Lending rate is over 4%, lending with a margin of 3% is likely to be a loss. As suggested, a shared credit risk guarantee scheme is a necessity.

  • 5
    0

    Power greediness is the greatest enemy to this island. Even at the Corona crisis there is no hungry for peace, unity and effort to resolve the issues the country face. Racism is still the first priority of political and religious leadership. Srilanka appears to be a country of anti western, anti Indian and anti minority. Most of the income coming from these sources. China can give loans with conditions and high interest. How long?

  • 6
    1

    If small and medium size businesses sink, banks will be hurt.
    Should not the major banks be brought into the process of evolving a strategy.
    We always think of the businesses and banks.
    There are the self-employed and many small businesses that rely on other (easy access but rather harsh) financial resources. Should not our economists give some thought to them as well.
    *
    BTW
    The mask is badly worn by the Governor.
    The image does neither him nor CT any good.

  • 4
    1

    Remember, loan is worth to take at 4% if the ROI is above 4%. How many projects in Lankawe are guaranteed for that? Why Lankawe fell into so many white elephant projects? Why the exporting garment factories shutting down? Why the estate industry is suffering? Why 1 Million went to Middle East to Cooli jobs? Why the exchange rate couldn’t be fixed any Aanduwa? Tamil Nadu is described as the Detroit of South Asia. Why didn’t any of those manufactures think of more South, in Lankawe? Why didn’t Volkswagen didn’t’ open the factory it promised? Japan pulled off from express train project. Iran came back to UMA Oya. How the Bank loans at 4% solve any of this?
    The car is, broken but Lankawe has brought is to trace track to fix. Yes, the drivers fix their cars on trace tracks, but that is only maintenance fixes. Will it bend in 50s while it couldn’t in 5s? In 2015, Lankawe economy went bankruptcy and Old King ran out of Temple Tree House, not knowing what to do for that. Now came back & pretends like he will fix it with additional Covid-19 problems. “While the iron rods are flying in the sky for strength of the wind (Covid-19), what the Kapok cotton can do?” Covid – 19 is not the time to correct 70 years of corrupted political culture to uplift economic upheavals.

  • 3
    1

    There is no honest solution is being issued in by the CB loans. It is only time delaying technique until election gets out of their way. Real plans will come out only after that. Until that, Central Bank will be depositing the loan credits in Royal’s Foreign Bank Accounts; nothing will go to local banks for loan lending. It didn’t happen during Chitanta government time. It didn’t happen in Yahapalanaya time. It will not happen now with CB. Period!
    My guessing is Royals might be having a plan to dispose many assets to China to bring down the loans. Remember, it was Old King’s Idea to sell Hangbangtota project to China, with 7500 acres land. But it was Ranil who sold it with 15,000 acres land. During the negotiation time, China will cash more white elephants in. Banthula is repeatedly declaring that his government has no idea of taking MCC grants. MCC grant need not be the only solution, but not accepting it tells the Aanduwa is still on the same track of past 70 years, where it bets.
    Poor Mother Lankawe is caught on real extractor’s hand. If the milk (Commission) is not coming, they are grinding the cow’s nipple to extract milk. When Old King rushed for his commission in Homagama Stadium, Elder Brother Prince was betting for Australian cows in this hard time. Is this how one fixes the Covid – 19 recessions?

  • 3
    0

    The Central Bank has approved Rs: 28 Billion loans at 4% interest, with 6 months grace period to be disbursed among 13,681 businesses affected by the Covid-19 outbreak……
    This came high on the heels of the meeting the President had with the Governor Central Bank and his Top officials a few days ago.
    Obviously, the small fry will not find themselves on this list!

    • 3
      1

      Plato,
      By any chance do you know how many of these loan approvals are swabasha rajapuka loyalist goons.?
      =
      What will be the percentage of the loans will ever be repaid.?

  • 2
    0

    Stimulus checks should be posted out to needy citizens and local industry. Banks and treasury to consolidate all money into one single unit instead of pre-covid19 marketplace. Building up to begin mostly at ground level with low interest repayments. Big boon to the local industry. Multi-lateral corporations to go temporarily bust (although most are still doing well, and should be taxed appropriately), but can take off again if a vaccine is successful. Taxation to be paid for in kind, e.g. reduction in salaries and wages – mostly salaries.

  • 1
    0

    Sri Lanka Treasury & Central Bank Should Consider Credit Guarantees For Covid-19 Distressed Bank Loans.

    *** It must be obvious to any one despite bold statements by Gotha and MR the Country is doomed to fail under them because no Country has the money or willingness to come to the rescue. The GOSL rumour machine is puttinng out false statements to influence the outcome of the election. Let us look at the evidence.

    1) IFS has not responded to the request for $1.5 Billion. and are waiting for the outcome of the election . If MR wins with a predicted 2/3rds it will be icing on te cake. and the loan will be refused.
    2) Gotha begged Inda for $1.1 Billion immediately. India is going through difficult Economic meltdown.
    3) Cheenavedi cant give and wont give.
    4) Karuna is a side show. and if anything it was Gotha who made the Killer of 3000 Soldiers a minister.

    For Gotha it is back to basics. Only TRUMP has thrown $1 million into the ” Pichai Pathiram”

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