economic capsule - may 2014

Economic Capsule

May 2014

Research & Development Unit

ECONOMIC & BUSINESS NEWS

Group Results as at 31 March 2014

Moody's: Sri Lanka Guarantee on Pawning Loans Is Credit Positive for Banks

FINANCIAL SECTOR NEWS

Central Bank Relaxes Forex Regulations

Sri Lanka Continues to Improve on UN-ESCAP Parameters

External Sector Performance March 2014

Inflation – April 2014

SNIPPETS

ANALYSIS & FORECAST The Credit Dilemma: Monetary and Financial System

Stability in Sri Lanka

C O N T E N T S

BANKING NEWS

< Research & Development Unit >

Commercial Bank Posts Q1 Pre-tax Profit of Rs 3.291 Billion

The Bank’s net interest income for the three months grew 17.07% to Rs 6.571 bn.

Loans and receivables totaled Rs 418 billion at the end of the period reviewed, while total deposits reached Rs 481 billion.

The Bank’s capital adequacy ratios stood at a healthy12.84% for Tier I and 16.34% for Tier I + Tier II, well above the minimum statutory requirement of 5% and 10%.

According to Commercial Bank Managing Director Mr Ravi Dias, “The Bank recorded healthy growth in net interest income despite narrowing margins through an increase in interest-earning assets and timely re-pricing of assets and liabilities.”The Bank had also achieved gains from trading and financial investments and contained the growth in expenses to under 10% in the period reviewed he said, adding that the Bank had also maintained the momentum of deposit growth, averaging more than Rs 5 billion a month.

Commercial Bank reported operating profit before VAT and NBT of Rs 3.897 bn for the three months ended 31st March 2014, reflecting growth of 4.73% over the first quarter of 2013. Operating profit after VAT and NBT (PBT) grew by a modest 1.88% to Rs 3.291 bn, with VAT and NBT for the three months totalling Rs 606.3 mn, an increase of 23.53%.


Moody's: Sri Lanka Guarantee on Pawning Loans is Credit Positive for

Banks

"Although the government's details on the mechanism are scant at this stage, Moody’s estimate that a partial guarantee is more likely because of the government's constrained fiscal capacity and the history of government guarantees," according to Nick Caes, a Moody's Associate Analyst. "Still, even a partial guarantee would be credit positive for Sri Lanka's banks because it will support the currently weak quality of their pawning loans, which constituted a substantial part of the recent increase in banks' nonperforming loans.”.

Although the new guarantee scheme will focus only on new pawning loans, Moody's expects that the scheme will allow existing borrowers to refinance their pawning loans, perhaps even at a lower rate, leading to improvements in the quality of the asset class for the banks.

According to Moody's Investors Service the guarantee on pawning loans proposed by the Central Bank of Sri Lanka will support the weak quality of pawning loans of banks, which constitute a substantial part of the recent increase in banks' nonperforming loans.

On 20.04.2014, the Central Bank of Sri Lanka announced that it will implement a credit guarantee scheme on so-called pawning loans of licensed banks, which in Sri Lanka are typically backed by gold. The guarantee will be implemented by the central bank of behalf of the government of Sri Lanka.

Source: Moody’s


Fitch: Sri Lanka Credit Guarantee Positive for Pawning Loans

A central bank-backed guarantee scheme for bank lending secured against gold (pawning advances) should help to reduce the build-up of NPLs in Sri Lanka's banking system, says Fitch Ratings. Gold-backed lending peaked at about 19% of total banking sector loans at end-2012, but the decline in gold prices in 2013 has subsequently contributed to a rapid deterioration of asset quality.

Aggregate system NPLs rose to 5.6% of total lending at end-2013 (from 3.7% at end-2012) with 75% of the increase accounted for by gold-backed loans. In response, Sri Lankan banks have tightened lending requirements, reducing loan-to-value ratios and raising interest rates for gold-backed credit.

Details regarding the implementation of the programme and the extent of its coverage have yet to be released, but the Central Bank of Sri Lanka (CBSL) aims to increase loan-to-value ratios to a maximum of 80% (from 65%) and cap interest rates at 16% per year. This is part of a broader goal to support economic activity in agriculture and SMEs, which are the primary sectors that have historically taken advantage of pawning advances.


Fitch: Sri Lanka Credit Guarantee Positive for Pawning Loans (cont…)

The scheme is credit positive in the short term, and will benefit banks directly in two principal ways. First, by sharing credit risk with the central bank, it will enable the banking sector to reverse a rapid decline in gold-backed lending - pawning advances fell by 17% in 2013 on the back of falling gold prices and tightened credit conditions. Second, it is likely to improve overall bank asset quality by reducing the build-up in NPLs.

The short-term effects of a credit guarantee scheme are positive for Sri Lankan bank asset quality, while we highlight that the existing regulations concerning gold-backed lending lead to unrealistic assessments of credit risk. In our view, the 0% risk-weight applied to gold-backed credit exposures under Sri Lankan regulations mis-characterises the risk associated with such loans - which may be "low risk" but are not risk free. A significant share of gold-backed loans lie on the books of the country's largest state banks, whose reported capital adequacy ratios would be much lower if a higher risk weight were applied.

Source: Fitch

Economic & Business News


Central Bank Relaxes Forex Regulations

Permission to foreign investors to invest in debentures of companies incorporated in Sri Lanka Foreign investors will be allowed to invest in non-listed debentures, in addition to listed debentures, through the Securities Investment Account (SIA).

Widening the eligibility to obtain an Electronic Fund Transfer Card (EFTC)Holders of Migrant Blocked Accounts, SIA, Diplomatic Accounts etc. will be allowed to obtain debit cards.

Issuance of Foreign Travel CardsA general permission will be granted to Licensed Commercial Banks (LCBs) to issue travel cards to their customers.

Increased facilities to resident foreign exchange earnersForeign Exchange Earners’ Account (FEEA) holders will be allowed to make payments relating to foreign

contracts out of the existing funds in the FEEA, LCBs will be allowed to provide loans in foreign currency to FEEA holders. In addition, several amendments that have been made on a piece meal basis from 2012 onwards, will be

consolidated.

Removal of the minimum balance requirement for Special Foreign Investment Deposit Account (SFIDA)The current requirement of maintaining a minimum balance in SFIDA accounts will be removed.

Cont…


Central Bank Relaxes Forex Regulations (cont…)

Remittance of living expenses in advance to obtain student visasA general permission will be granted for LCBs to facilitate transactions of students to open accounts with a foreign bank, if such

students intend to proceed outside Sri Lanka for their studies.

Such payments also could be remitted through a Resident Foreign Currency Account, a Resident Non National Foreign Currency Account, or a Foreign Currency Account for International Services Providers and their Employees (FCAISPE).

Credit facilities to importers resident in Sri Lanka, by suppliers resident outside Sri LankaThe time restriction that was prevalent on supplier’s credit for importers will be removed.

Letters of CreditThe prevailing restriction on extending a Letter of Credit (LC) will be removed.

Source: CBSL


Sri Lanka Continues to Improve on UN-ESCAP Parameters

Sri Lanka has continued to improve its external debt sustainability indicators, as computed in accordance with the Manual of Effective Debt Management of the United Nations Economic and Social Commission for Asia and the Pacific (UNESCAP).

In that regard, of the six external debt indicators that are used to assess the external debt vulnerability of a country, Sri Lanka is placed in the “less indebted” category in five external debt indicators in 2013. In the remaining indicator, Sri Lanka is placed in the “moderately indebted” category.

Indicator

Critical values of external debt indicators

Debt indicators of Sri Lanka

LessIndebted

ModeratelyIndebted

HighlyIndebted 2012 2013

Disbursed External Debt Outstanding/Gross National Income <30% > 30% and

<50% >50% 37.2% 35.1%

Disbursed External Debt Outstanding/Exports of Goods and Non-Factor Services <165% >165% and

<275% >275% 111.1% 106.6%

Total External Debt Service Payments/Exports of Goods and Non-Factor Services <18% > 18% and

<30% >30% 11.4% 11.2%

External Interest Payments/Exports ofGoods and Non-Factor Services <12% > 12% and

<20% >20% 3.6% 3.9%

Net Present Value/Gross National Income <48% > 48% and<80% >80% 40.4% 39.8%

Net Present Value/Exports of Goods and Non-Factor Services <132% >132% and

<220% >220% 124.9% 121.0%

Assessment of External Debt Vulnerability of Sri Lanka – 2013(As per the parameters defined in the manual on Effective Debt Management of the UN-ESCAP)

Source: CBSL


External Sector Performance March 2014

Category Jan-Mar

2013 US$ mn

Jan- Mar 2014

US$ mn

Growth Jan- Mar

(%)

Exports 2,358.4 2,808.9 19.1

Agricultural Products 551.2 661.0 19.9

Tea 333.6 387.0 16.0

Industrial Products 1,800.2 2,106.7 17.0

Textiles and Garments 1,050.0 1,264.8 20.5

Mineral Products 4.0 37.6 831.5

Imports 4,510.3 4,670.7 3.6

Consumer Goods 711.2 780.4 9.7

Intermediate Goods 2,640.4 2,906.0 10.1

Fuel 1,094.0 1,368.1 25.1

Textiles and Textile Articles 496.2 528.2 6.4

Investment Goods 1,156.6 981.9 -15.1

Deficit in the Trade Account -2,151.9 -1,861.8 -13.5

Overall BOP Position During the period January to March

2014 the overall BOP is estimated to have recorded a surplus of USD 828.3 mn compared to a surplus of USD153.6 mn recorded during the corresponding period of 2013.

International Reserve Position Sri Lanka’s gross official reserves amounted to

USD 8.1 bn by end March 2014 & in terms of months of imports, gross official reserves were equivalent to 5.3 months of imports.

Cont…


External Sector Performance March 2014 (cont…)

Source: CBSL


Inflation – May 2014

Inflation, as measured by the change in the Colombo Consumers’ Price Index, decelerated further to 5.3 % in May 2014, on an annual average basis, from 5.6 % in April 2014. This is the twelfth consecutive month, in which inflation has fallen continuously from high of 8.8 % in May 2013.

Inflation on a year-on-year (YoY) basis decreased to 3.2 % in May 2014 from 4.9 % in the previous month, mainly on account of the base effect.


SNIPPETS

Sri Lanka Drops from The Networked Readiness Index Sri Lanka has dropped a startling 7 places on this year’s Networked Readiness

Index from 69 to 76 out of 148 countries. The Networked Readiness Index is a comprehensive analytical tool that is published

annually and which measures the readiness of countries to utilize Information and Communication Technology.

Govt. to Change GDP Compilation Method Sri Lanka is to upgrade its Gross Domestic Product (GDP) compilation method to

reflect international standards from next year, according to Mr. D.C.A. Gunawardena, the Head of Department of Census and Statistics.

The Department of Census and Statistics plans to introduce the new method from the first quarter of 2015 and it will be compiled according to the latest international statistical standard for the national accounts. The base year will move to 2010 from 2002.


SNIPPETS

India's TATA Housing Starts Sri Lanka Property Project The TATA Housing Development Company has pledged an investment of US$ 430 mn towards

the proposed commercial and residential complex at Slave Island, Colombo 2. Under the project, three apartment blocks comprise of 40 stories each containing 580 housing

units will be constructed. In addition, the company also plans to build 96 luxury housing apartments. Construction work is expected to be complete within a period of two and half years. During the construction period each displaced family will be paid a house rental allowance starting from Rs. 15 200 to Rs. 52,000.

Sri Lanka Borrows US$ 175mn from ADB for Roads, Education The Asian Development Bank stated it would loan USD 175 million to build roads and boost the state university system to generate graduates that more employable.ADB will give USD 100 million for Sri Lanka government's skills sector development program which plans to reduce a mismatch between the competencies of graduates and skills needed by employers. ADB will also lend USD 75 million to improve 33.5 kilometres of national highways linked to the island's Southern Expressway.

Analysis & Forecast


The Credit Dilemma: Monetary and Financial System Stability in Sri Lanka

February 2014 marked five consecutive years of single-digit rates of inflation in Sri Lanka – supposedly the longest spell in the country’s post-independence history. Inflation rates hit a peak of 22.6 % in only 2008 before settling to single digit levels from February 2009.

Despite five years of a moderate inflationary environment and higher average economic growth during that period, private investment trends have been modest. The monetary authorities are struggling to revive credit appetite in spite of signaling the end of a tight monetary policy stance way back in December 2012.

Credit growth to the private sector was extremely sluggish at 7.5 % in 2013. It has continued in the same vein so far in 2014, recording a growth of only 4.4 % year-on-year in February. The private sector thus seems to be rather indifferent to the successful slaying of Sri Lanka’s inflation bogey, and inducements to borrow for investment.

The latter has been pushed through an aggressive easing of monetary policy: A 25 basis point reduction in policy rates in December 2012, followed by a further rate reduction of 50 basis points in May 2013;slashing the Statutory Reserve Requirement (SRR) of Licensed Commercial Banks (LCBs) by 2 percentage points from 8 % to 6 % in June 2013; requiring all LCBs to reduce penal rates of interest charged on all loans and advances including credit facilities already granted to a level not exceeding 2 per cent per annum, whilst finance and leasing companies were requested to reduce the penal rate of interest to 3 %per annum from August 2013; and a further policy rate cut of 50 basis points in October 2013.

By Dr. Dushni Weerakoon Deputy Director - IPS and Head of Macroeconomic Policy Research


The Credit Dilemma: Monetary and Financial System Stability in Sri Lanka (cont…)

Lending rates that remained fairly sluggish in the first half of 2013 owing to high government borrowing have adjusted. The Average Weighted Prime Lending Rate (AWPR) fell from 14.4 % in February 2013 to 9.4 % in February 2014.

The reasons for the overdue credit pick-up are perhaps partly explained by Sri Lanka’s growth pattern of recent years.

Much of the higher growth is coming from non-tradable services sectors and industry sectors such as construction and utilities. Many of these also have large state involvement.

Booming sectors where businesses can plug-in investments is more limited than the overall high GDP growth numbers would suggest. Not surprising then that in times of credit growth, much of it goes into consumption and related sectors.

A second explanation lies in past over-kill in pushing credit up-take by the private sector. Sri Lanka found itself grappling with a more complex monetary and exchange rate policy setting post-2007 in the face of high domestic demand financed by external debt.

As capital flows in, if monetary authorities choose to intervene in the foreign exchange market to hold the currency from appreciating, it leads to an expansion in the monetary base and the potential for greater liquidity in the economy and excessive credit growth.



There was excessive credit growth in 2007-08, alongside rising inflationary pressure. The monetary policy response was slow, allowing real interest rates to be negative over time, fuelling a culture of ‘cheap credit’ (Figure 1).

Credit growth to the private sector peaked at over 25 % in mid-2007, with significant growth in consumption and housing related loans, before being brought under control by year end.

Despite high inflation and a sharply deteriorating current account, intervention to maintain stability in the exchange rate saw Sri Lanka teetering on the edge of a balance of payments crisis, averted after an agreement with the IMF in 2009. The reckoning came in the form of lower growth and a weakened private sector appetite for credit.

From mid-2010, Sri Lanka once again began to push for private sector credit growth. Policy rate adjustments, abandoned in favour of reserve money as the primary operating target for monetary policy in 2007, got underway from mid-2009.



The banking sector, yet to fully recover from the excesses of the preceding credit boom that saw gross non-performing loans (NPL) ratios rise to 8.5 % in 2009 were subject to moral suasion to speed up lending to the private sector.

Credit growth to the private sector accelerated from mid-2010 – even as policy rates remained unchanged throughout 2011 – fuelling an import surge and precipitating the imposition of a mandatory ceiling on commercial bank credit growth.

Sri Lanka once again tried to hold the currency steady against a sharply deteriorating current account and was compelled to change direction by reversing import tariff reductions and adopting a flexible exchange rate policy in February 2012.

The latest round of monetary policy easing comes in the wake of a doubling of credit growth to the private sector between 2009 and 2012. It is perhaps not surprising that the credit overload of the past is still to work its way through the economy, deterring fresh uptake by the private sector. Such excesses constrict not only investors, but also the financial sector as well.



Credit booms have been fuelled by consumption (Figure 2). In 2010-12, the take-off in pawning-related consumption lending that suffered subsequent to a drop in gold prices added to the distress.

With a slower rate of economic output post-2012, the combined impact has been to expose the banking sector to rising NPLs just as the ratio stabilized after the last credit bout. The gross NPL ratio for banks climbed sharply to 5.6 % in 2013 while that for the non-bank finance institutions (NBFIs) rose to 6.7 %.

On the heels of yet another NBFI facing liquidity problems in 2013, the CBSL announced a proposed financial sector consolidation plan. Whilst it undoubtedly has long term objectives, the immediate concern is primarily to minimize systemic risks posed by deposit taking institutions deemed to be at some risk. The immediate consolidation process aims to bring down the numbers of NBFIs from 58 to 20.

Whilst financial sector consolidation is in the right direction, obligatory mergers and acquisitions may not be the most efficient way to set about it.

In the long term, efficient financial intermediation to support economic growth and stability comes from prudent monetary and exchange rate policy management, and regulatory oversight. The Sri Lankan economy has been subject to ‘stop-go’ policy cycles since 2008 – an acutely unsettling phenomenon for private sector investors. A moderate inflationary environment alone will not induce greater investor appetite. Investors and financial institutions must be also offered a measure of policy consistency and stability, be it in setting exchange rate policy, interest rates or other regulatory requirements.

The views expressed in Economic Capsule are not necessarily those of the Management of Commercial Bank of Ceylon PLC

The information contained in this presentation has been drawn from sources that we believe to be reliable. However, while we have taken reasonable care to maintain accuracy/completeness of the information, it should be noted that Commercial Bank of Ceylon PLC and/or its employees should not be held responsible, for providing the information or for losses or damages, financial or otherwise, suffered in consequence of using such information for whatever purpose.

economic capsule - may 2014

Economy & Finance