Shortly after he became Prime Minister again on November 29 last year, Mahinda Rajapaksa invited the chief executives of the country’s banking sector to a meeting with his senior economics advisor and former central bank governor, Nivard Cabraal.
Rajapaksa and Cabraal purportedly wanted the banks to roll out a 12- to 18-month moratorium on their entire loan portfolios to get the Sri Lankan economy back on its feet again. It is not hard to imagine the stunned silence and consternation that must have greeted such a request.
As negotiating tactics go, it was one straight out of the US president’s playbook. Ask for something completely outrageous knowing that your opposite number will almost certainly sigh with relief when you settle for what would never have been willingly offered in the first place.
And so it has come to pass. The end result of that rumoured meeting was a working group to examine what kind of package the banking sector could put together to lift GDP growth from the 2.9% the International Monetary Fund (IMF) has estimated for 2019.
This January, the fruits of discussions between the government and banking community led to the announcement of a one-year moratorium on principal re-payments and a new credit programme for eligible small and medium sized enterprises (SMEs), which account for 52 % of Sri Lanka’s GDP.
The moratorium is far wider than a similar one extended to the tourism sector after the Easter Sunday terrorist attacks last year.
The international rating agencies have taken a dim view of it on the grounds that SMEs might take a relaxed attitude to debt repayment and non-performing loans (NPLs) will spike once the moratorium ends. System-wide NPLs were already at 4.9% as of end October, a high level by historical standards.
Moody’s described the moratorium as credit negative for the sovereign’s B2 rating, while Fitch and S&P have both downgraded the outlook on their respective B ratings from stable to negative. All three rating agencies are also well aware that the reason Sri Lanka ended up under an IMF programme in the first place is because of a lack of fiscal discipline towards the end of Mahinda Rajapaksa’s last stint in power.
However, the view on the ground in Colombo is one of cautious optimism. Jonathan Alles, CEO of Hatton National Bank (HNB), told FinanceAsia that, “the moratorium will help the SME sector to flourish if it’s applied properly.”
Over the past few months, it has also become clear that while the Rajapaksa family are back in power, they appear to be adopting a more geopolitically balanced approach to international relations and a very different economic strategy. Consumer consumption and business investment are now favoured over the grand and, in a number of cases, ill-conceived infrastructure projects, which marked their previous time in office immediately after the civil war.
There has also been a shift in power and style, as Gotabaya Rajapaksa becomes president in place of his brother Mahinda. The former’s military background has given him a fearsome reputation for discipline and control in sharp contrast to the preceding five years of coalition government, which were marred by infighting and poor execution.
He has taken to making spot checks. These have reportedly had a galvanising impact on officials who might otherwise have spent the afternoon with their feet up on their desks.
His personal authority, combined with no small measure of the fear factor, may yet help to re-vitalise the country’s moribund state-owned sector, which will be key to sustainably higher GDP growth. Indeed, one of his first steps was to appoint some of the country’s most well-respected business leaders to head key state entities in the hope they can reform them from within.
Susantha Ratnayake has become chairman of the Board of Investment after four decades at the country’s leading blue chip, John Keells Holdings, most recently as chairman. Meanwhile, debt-laden and scandal-hit, SriLankan Airlines gains Ashok Pathirage, founder of the Softlogic conglomerate, as its new chairman.
The crony count has, so far, been very been low, surprising both the family’s supporters and its critics. It has created a lot of positive sentiment.
Many hope this is a sign that Gotabaya Rajapaksa will become a transformational and respected national leader in the mould of Indonesia’s Jokowi rather than join the ranks of the world’s corrupt rulers who are more interested in state capture than inclusive growth.
On the economic front, the government has tried to boost growth by sweeping tax cuts. VAT has been reduced from 15% to 8% and companies have been told there will be “consequences” if they do not pass it on. A 2% nation building tax has also been scrapped, as has capital gains tax on stock market profits.
The rating agencies worry that the tax cuts are too deep and will create a yawning fiscal gap. Local economists, on the other hand, have been broadly encouraged.
“The tax cuts were a short-term measure, but they were much needed as it gave business and consumer confidence an adrenaline shot,” said Asia Securities economist, Lakshini Fernando.
It appears to have worked. The Business and Consumer Confidence Index has almost doubled from 100 to 200 points in the space of just two months.
Asia Securities is forecasting that growth will jump to 4% in 2020 and credit growth from 4.5% in 2019 to 15% in 2020. CT CLSA predicts 4.3% and 12%.
Government economics advisor Cabraal believes that even 6% GDP growth is achievable if the country’s two key Chinese-led projects - Colombo’s upcoming port city and a port in Hamabantota - start to deliver results. The Gotabaya administration believes that FDI is the key to bridging the fiscal gap over the medium-term.
HSBC’s CEO, Mark Prothero, is optimistic. “Stable government gives investors confidence,” he said. “But investors will also want clarity about how the government plans to manage the deficit over the longer term.”
Both Asia Securities’ Fernando and her CT CLSA counterpart, Sanjeewa Fernando, agree that a medium-term fiscal framework will be essential to reassure investors that the country will not slide back into the arms of the IMF. However, this is unlikely to happen until after parliamentary elections in the spring, which will, in turn, determine just how strong a hold the Rajapaksas will have over the machinery of government for the next five years.
In the absence of an imminent fiscal framework, Asia Securities is maintaining a drop off in the growth momentum during 2021 to 4.3% and CT CLSA to 5.5%.
The rating agencies, meanwhile, remain keenly focused on what the new government plans to do to improve revenue collection and particularly the tax to GDP ratio. In Sri Lanka’s case, this stood at just 11.85% in 2018, down from the 14% level one decade earlier.
The new government hopes that consumer and business spending will create a bigger revenue base to tax. But there is also general consensus that it needs to widen the net too.
There are currently 700,000 tax files open at the Inland Revenue department compared to an estimated taxable base of 1.5 million people under the government’s new classifications.
As CT CLSA’s Fernando explains, “The previous government did some of the legwork to determine who should be paying income tax by starting to profile documents such as vehicle registrations and land ownership deeds."
But he adds that they never had the political capital to implement their findings. Fernando believes this will no longer be the case with the new administration.
“They've stated their determination to do deeper profiling and have also set a much higher tax threshold of LKR250,000 ($1,380) per month compared to the previous government’s LKR100,000 threshold,” he remarked. “This new classification is more popular because it excludes the middle class, while earners above LKR750,000 will face higher taxes still."
BANKS: A STRUCTURAL IMPEDIMENT TO GROWTH?
When it comes to the banking sector, stock market valuations have not yet benefitted from the new policy direction: quite the opposite, in fact.
The country’s two leading private sector banks, Commercial Bank and HNB, have both underperformed the Colombo Stock Exchange All Share Index over the past five years despite recording a 50% plus jump in profits between 2015 and 2018.
S&P Capital Global Market Intelligence data shows that Commercial Bank’s price-to-book ratio has dropped from a 2.08 times average in 2015 to 0.84 times in 2019. HNB has gone down from 1.3 times to 0.63 times over the same period.
These valuations are not only half the level of frontier market peers in nations such as Vietnam and Pakistan, but also nearly half the level the two were accustomed to before the previous government decided to go after their turbo-charged profits.
Some believe the banking sector, as a whole, only has itself to blame after proudly trumpeting record profits on the front pages of national newspapers year after year. It made them very soft targets for the coalition government, which was desperately searching for cash to meet its IMF targets.
Most notable was the imposition of a debt repayment levy, which took the form of a 7% hit on the banks’ taxable profits. This was also introduced at a time when the banks were in the process of having to boost their capital to meet Basel III requirements and adjust their provisioning levels ahead of IFRS 9 implementation.
As a result, the top banks’ return-on-average-equity ratios (ROAE) have dropped from around 20% at their peak in 2016. In 2018, they were down to 15.48% (Commercial Bank) and 14.58% (HNB).
Nevertheless, these are still very healthy ratios compared to Bangladesh and Pakistan where the top banks fall in the 12% to 13% bracket. Net Interest Margins (NIMs) have also remained in the high three- to mid five-percent range.
In many ways, Sri Lanka is just like other frontier market where the banking sector is an outsized GDP driver. There is typically a very marked gulf between inefficient state-owned banks stuffed with undisclosed NPLS and nimble private sector competitors, that live very well on the spread between the low rates they pay on their large deposit bases and the high rates they charge when they lend the money back out.
Making sure there is an alignment between the banking sector’s priorities and the country’s long-term economic interests will, therefore, be pivotal to how Sri Lanka performs over the coming five years. Some believe that the country’s private sector banks are almost too good at making profits, in the process stifling long-term growth because they are simultaneously too conservative in their lending practices.
Small companies, in particular, frequently complain they cannot get access to funding, or end up in a death spiral after being hit by punishing penalty payments if they suffer cash flow problems after a bombardment of unforeseen externalities such as floods, droughts, terrorist bombs and most recently, the coronavirus.
Does this mean the Sri Lankan banking sector has a structural problem? On the plus side, the banks provide very firm foundations for the rest of economy.
As Asia Securities, head of research, Kavinda Perera puts it, “The banks’ evaluation processes are very stringent and they’ve always been conservative in their lending policies. But I tell investors this means there aren’t systemic risks here as there are in other frontier markets.”
Conservatism has also been the central bank’s watchword in recent years. It introduced IFRS 9 in the fourth quarter of 2018, ahead of a number of regional peers that have yet to do so.
It was also quick to clamp down in 2014 when the banks did start accelerating loan growth above 20%. Problems relating to structurally high lending rates are as much a function of the government’s economic policy as they are about banks’ profitability.
One key change that everyone does agree on is the need for a far smoother interest rate cycle. HNB’s Alles comments that, “when interest rates were low, companies used an IRR to underpin their business planning, which they couldn’t sustain when rates shot up thanks to increased government borrowing and a higher fiscal deficit.”
In early October, the central bank tried to bring lending rates down by telling the banks to reduce their prime rates by at least 250bp below April 2019’s 12% level. However, the government has also deployed a carrot as well as a stick, getting rid of the much-hated debt repayment levy.
Local economists say that all the government’s tax cuts will bring banks’ effective tax rate down from 52% to 39%.
However, as CT CLSA’s Fernando adds, “during the first year, this benefit will be passed onto SMEs through the moratorium. But it will help banks to achieve 15% ROEs again from the second year.”
That is unless there is another moratorium before then. And another one is already rumoured to be in the government's line of sight to handle the fallout from the coronavirus on the tourism sector.
The banks themselves have been pretty positive about the government’s recent actions.
“I’ve told my team to view the SME moratorium as a positive approach,” Commercial Bank’s CEO, Sivakrishnarajah Renganathan, told FinanceAsia. “When it comes to SMEs that have asked for new credit facilities, we will provide them with a time period to settle the capital repayment and then evaulate and identify, which ones have a good case and support them further.
“This will be good for the bank and the country,” he continued. “It’s been a challenging time for the economy over the past few years, but it’s not like it was during the war when the unpredictability of events made it hard to produce forecasts. This is a very different scenario and one we can overcome.”
The rating agencies remain concerned that SMEs will use their new funds to buy cars, houses, or equities. This may give the economy a short-term boost, but will leave them with re-payment difficulties and dampen economic activity further down the road.
The banks counter this by saying that they are weeding through the applications.
Both Alles and Renganathan believe that ultimately Sri Lanka would benefit from an SME-focused development bank, something the government has said it is looking at.
“It makes a lot of sense,” stated Renganathan. “Commercial banks will defer capital re-payments for short-periods if it makes business sense, but not for the longer-term periods that a development bank can offer.”
Alles agrees. “Should it happen and could it happen?” he remarked. “I’d say yes on both counts.
“It wouldn’t have to be a new bank either,” he added. “It could encompass parts of the existing system including the state mortgage corporation and some co-operative societies.”
It would also likely need to take in parts of Sri Lanka’s two big state-owned banks: Bank of Ceylon and People’s Bank. Both represent a political quagmire that politicians have long hesitated to tread in for fear of sinking.
Does this make an SME development bank a non-starter? Once again, there is hope that Gotabaya Rajapaksa has the strength to untie the Gordian knot.
One economic advantage the new administration does possess is a longer sovereign debt maturity profile. It has its predecessor’s smart international borrowing strategy to thank for this.
As a result, there is just one $1 billion international bond issue that falls due this October. Overall, the sovereign does have to re-pay or re-finance $4.8 billion in overseas debt over the next 12 months compared to $7.63 billion in foreign exchange reserves at the end of January.
However, it has a greater measure of breathing space from imminent balance of payment difficulties.
Alles says he is feeling positive about the next two to three years and is very keen that the new government “walks the walk” rather than engages in more rounds of talking.
“We all know what the country needs,” he concluded. “If the government stays focused and serves the people with honour, as they say they want to, then there’s a great opportunity for all of us here in Sri Lanka.”