Financial sector stable despite global crisis

Gamini Warushamana interviews

Central Bank Governor Ajith Nivard Cabraal

Q: You repeatedly said that the Banking system in Sri Lanka is stable and will not be affected during this global financial crisis. However, the situation has changed. Some financial institutions and commercial banks are under threat. How do you explain this situation? Is this a result of the global financial crisis or that of a local issue linked with unregistered financial companies?

A: Since late 2007, the world faced several shocks. The sub-prime issue that began in the latter part of 2007 turned into a global financial crisis within a year. The shocks from the increasing food prices and fuel prices too exacerbated the position. To address the situation, major central banks reduced their policy interest rates and stabilized financial markets by aggressively providing liquidity. Further, several Governments undertook measures such as placing troubled financial institutions under government control and injecting funds. They also substantially expanded deposit insurance coverage, provided guarantees for financial institutions’ debts and provided relief packages to revive the banking industry and lessen the impact on the economy.

The impact of the sub-prime turmoil on the Sri Lankan financial system has been rather limited and the overall performance of financial institutions remains satisfactory. On the whole, financial institutions continued to be profitable and reasonably well capitalized with ongoing improvements in risk management capabilities supported by an enhanced regulatory and supervisory framework and oversight. Some of the recent policy measures adopted by the Central Bank that included the implementation of the Direction on Corporate Governance, requirement to maintain capital on Basel II capital standards, requiring improved risk management practices and a 1% general provisions on regular loans. As a result, stronger financial positions had been built up in these institutions in recent years, and that has enabled these institutions to cope with the increased levels of risk.

Therefore, the overall Sri Lankan financial sector continues to remain stable despite the global financial crisis.

Following the announcement by the Chairman of Ceylinco Group on 22 December 2008 of a major scam at one of their group companies, viz., the Golden Key Credit Card Company, some of the licensed financial institutions in the Ceylinco Group showed signs of stress. But now these risks and stresses are receding, and it is likely that conditions will return to normal soon.

Q: Can you explain the legal position that you used to rescue the Seylan Bank?

A: The Monetary Law Act provides wide powers for the Central Bank to intervene in a distress situation in the case of financial institutions. In view of the negative market development that severely affected the confidence of the public in Seylan Bank in late December 2008, and the potential danger that such a situation caused to the stability of the financial system, the Monetary Board took the necessary action to ensure stability, in terms of the Monetary Law Act.

Q: How does it work practically? Have you been able to restore the confidence of the depositors?

A: In order to restore confidence, the Monetary Board discontinued the services of the entire Board of Seylan Bank as at 29 December 2008, and appointed the Bank of Ceylon to carry on the business of the Seylan Bank.

Steps were also taken to appoint experienced bankers, eminent lawyers, and prominent administrative persons to the new board of Seylan Bank. The services of the incumbent CEO and all current employees of Seylan Bank, were retained without any interruption. Credit lines were also restored to meet urgent liquidity needs of the bank and the bank’s management ensured that sufficient funds were available to meet urgent deposit withdrawals.

At the same time, the Monetary Board informed the public that normal financial transactions should be continued with Seylan Bank and assured the public of the safety of deposits and the stability of the regulated financial sector. The public confidence on the bank has now been fully restored. This is confirmed by the upward movement observed in the share price of the Seylan Bank which reflects market confidence on the new management structure.

Q: Unregistered financial institutions have posed a threat to the whole financial system. Do you still think that educating people on the risk of such companies is enough?

A: It is absolutely essential that the public should be aware of the consequences of the investment decisions they make. People need to realise that the money they have earned should be invested carefully. However, some people still risk their money in unregulated enterprises. Although they have the freedom to do so, it is very unfortunate because they may sometimes lose their money because of their greed. We will therefore continue with our extensive programs to educate the public on the risks regarding investing in unregistered financial institutions. We are also taking steps to request Parliament to amend the relevant laws to give the Central Bank greater authority and ability to deal with such illegal institutions.

Q: The Global economic crisis has already hit our main export industries. Under this situation, what would be our growth forecasts for this year?

A: Our trade data up to November 2008 indicate that our exports have grown by 9.7 per cent during the year. This growth has mainly been in textile and garments, petroleum products, rubber products and diamond and jewellery sectors. The growth rate of imports during the year, which peaked at 35.4 per cent in July 2008, has declined to 27.9 per cent by November, 2008, effectively containing the trade balance from expanding further.

However, the uncertain nature of the current global economic situation, which has been dubbed the worst economic crisis since the 1930s, has made the extent of financial disruption on the domestic and international economies, unclear. In that scenario, we could expect a negative impact on our exports in 2009 mainly due to drop in demand due to lower demand emanating from key export destinations such as the USA, UK, Germany, Italy, France, etc. Our forecasts for 2009 also indicate a clear decline in exports. Fortunately, however, imports are projected to decline by an even higher rate. Therefore, the low growth of imports that is expected to prevail during the greater part of 2009, will result in a contraction of the trade deficit compared to the trade deficit in 2009, which would be beneficial for us.

Q: Many reports and experts have highlighted that Sri Lanka Rupee is overvalued by over 20% against our competitors and propose to devalue the rupee. Why is CBSL against the devaluation of the rupee?

A: The international value of the Sri Lanka Rupee is determined by the market forces of supply and demand in the local foreign exchange market; this should not be confused with imports and exports alone. In this regard, the Central Bank closely monitors developments in the foreign exchange market to avoid any sharp volatility in the market. Naturally, the foreign external market is subject to sudden disturbances in the external sector.

The stability of the exchange rate is more important in a commodity price boom like what we experienced during 2008. Therefore, the Central Bank had to intervene in the foreign exchange market to absorb and supply foreign exchange when the Central Bank believed it was appropriate, especially when sharp movements in exchange rates which are not warranted under normal economic conditions, may have been inclined to take place.

Arguments on the overvaluation of Sri Lankan Rupee is mainly based on two factors. These factors are the relatively higher inflation in Sri Lanka, and the sharp depreciation of some currencies of our trading partners and competitors. We have already successfully addressed the inflation issue.

Our inflation is now decelerating at a faster rate than that of our competitors.

Therefore, the relative disadvantage arising from higher cost of production is likely to erode in the near future. It is also important to note here that in Sri Lanka, interest rates are rapidly declining, fuel prices have been reduced substantially, and electricity prices have also reduced significantly. In addition, the government has introduced a support package to maintain the competitiveness of our exports. All these will add to our competitiveness. People should not think that competitiveness arises from the exchange rate only. They must remember that productivity and efficiency must also be given a lot of attention. Now, let us consider the second issue. That is the relatively sharper depreciation of other currencies vis-a-vis the Sri Lankan Rupee. In this matter, we expect this situation to be a somewhat short-term phenomena arising from the recent global financial crisis. Once financial market conditions improve, even slightly, it is likely that these other currencies would revert back to their original positions. Therefore, Sri Lanka’s rupee may not need to adjust sharply in response to such short term sharp fluctuations in world currencies, which has actually destabilized those economies and caused immense hardships to the people of those countries. We should not follow such courses of action blindly, without giving consideration to the many other factors that are impacted by the exchange rate. The Central Bank of Sri Lanka’s policy has been to maintain a reasonable stability in our exchange rate, while allowing some limited depreciation to maintain competitiveness, and that we think, will, someday soon, be acknowledged by many, as having been the better course of action. Let’s wait and see.

Q: Do you think that the sharp decline in commodity prices have passed to the consumers?

A: (Milk powder, essential food, fertilizer) Although commodity prices started to decline from July 2008 onwards, prices tend to be sticky with downward revisions, since it takes time for prices to adjust downward to reflect those of the international markets. This does not mean that there will not be an adjustment, but just that it will happen with a lag.In fact, we observe a decreasing trend in retail prices of essential food items such as wheat and dhal from July to November, 2008. With respect to milk food, there has been a reduction in the retail price of milk itself. However, the retail prices of other milk based products such as butter and margarine have increased during this period, possibly due to seasonal factors. At the same time, we also have to understand that in order to support the domestic milk industry, the price of imported milk powder needs to be maintained at a reasonable price, and that is why the government has increased the import duty on milk powder.

With respect to fertilizer prices, it is only the urea prices that have reduced on par with those of other commodities. Other types of fertilizer continue to be high in the world market. Since fertilizer is subsidized by the Government, changes in fertilizer prices are not expected to affect the consumers much.

Q: What is the level of our foreign reserves and fiscal deficit? Some sectors accuse that the CB does not give correct figures?

A: Central Bank has been regularly publishing data on key economic variables.

In this regard too, as we have already announced, the Gross Official Reserve position of Sri Lanka including ACU balances as at end 2008 was at US dollars 2,560.5 million. The Fiscal deficit as per the revised budget of 2008 was 7.0 per cent of GDP, as has been published in our “Recent Economic Developments” publication. In comparison, the fiscal deficit of 2007 was 7.7 per cent of GDP. Some people, when they don’t like the figures put out by us because it does not support their own dooms-day theories, tend to criticize the Central Bank, or the Department of Census and Statistics as we are the suppliers of information. That is actually very pathetic and reflects badly on the people making such accusations.

Q: How do you explain the decline in sovereign ratings of SL by Standard and Poor’s from B+ to B?

A: The recent cut in Sri Lanka’s credit rating by one notch from B+ to B was based on factually incorrect, logically untenable and grossly misleading information. The press release issued by the Central Bank of Sri Lanka immediately upon knowing of the rate cut clarified our position, and we would suggest that people look it up in our website. Sri Lanka’s debt burden has been easing significantly over the years. The public debt as a percentage of GDP declined to 85.8 per cent in 2007 from around 105.6 per cent in 2002, and is projected to decline to about 80% by the end of 2008.

On the political front, the government is stable with the participation of several political parties in Sri Lanka. On the security front, with the liberation of areas illegally controlled by the LTTE, and by substantially reducing the terrorists’ destructive capacity, the security situation has improved substantially. In that scenario, it is not possible for anyone to logically sustain the reasons for the rate cut. But, I guess rating agencies are now under tremendous threat themselves because of their poor performances and in that context, they may now be more inclined to downgrade developing countries, just to show that they are doing a good job. However, it is very strange that some institutions and countries that are having a lot of more serious troubles than us, are still retaining their high ratings.

Q: How will this affect our foreign borrowings, especially commercial borrowings?

A: In the light of ongoing financial turmoil, raising commercial borrowings has become very difficult across the globe. The resultant liquidity crunch and credit squeeze in the international market has already made commercial borrowings challenging for all borrowers in the international market.

Therefore, this will undoubtedly impact our foreign borrowings, particularly in the year of 2009. However, in the absence of the traditional commercial borrowings, the Central Bank has now initiated many new innovative measures to build up the reserves to a higher level. As already announced in our “Road Map: Monetary and Financial Sector Policies for 2009 and beyond”, some of the on-going activities are designed to fill this gap. First, we will enter into arrangements of currency swaps with certain central banks in order to boost our gross official reserves. Some central banks have already responded positively and two such negotiations are at an advanced stage currently. Second, we will start the active promotion of investments in Treasury bills and bonds among the Sri Lankan diaspora. Six lead managers that have been approved by the Central Bank have already taken many steps to promote these investments worldwide.

Third, with effect from 1st February 2009, a payment of a 20% bonus interest on NRFC and RFC deposits will be made as a special incentive to encourage higher levels of inflows into NRFC and RFC accounts. Fourth, we will encourage further inflows by Sri Lankans with perhaps only a marginal once-and-for-all concessional final income tax for any new foreign exchange inflows, if such inflows are liable to income tax. This incentive too, is expected to attract a significant inflow of foreign exchange into the country.

Q: How will the North and East contribute to the country’s economy in this year and thereafter? What are the plans, sources of financing etc. to rebuild the Northern and Eastern provinces?

A: The Eastern and Northern provinces presently contribute 5% and 3% of the country’s Gross Domestic Product (GDP), respectively. With the liberation of the Eastern province from the clutches of terrorism, a massive development drive is now on, in order to rehabilitate and reconstruct the social and economic infrastructure in the province while also resettling Internally Displaced Persons (IDPs).

The main program implemented by the government in this context is the Neganahira Navodaya, which has been given the highest priority by the government. With the progress of these measures, economic activities in the Eastern province are being revived and encouraged with a new impetus, thereby gradually enhancing its contribution to the country’s GDP. By now, most parts of the Northern Province have also been liberated by our Valiant Security forces. As a result, the main two access roads to Jaffna, i.e.The A9 and A32, have been cleared and their rehabilitation activities are now underway. With the opening up of these two roads, economic activities in Jaffna and the rest of the Northern Province will be reactivated with a renewed momentum. The benefits of this momentum will spill over to the rest of the country as well, particularly with enhanced economic activities from the Northern tip of the country, Point Pedro to the Southern tip, Dewundera.The program, Uthuru Wasanthaya, is now in its early stages to rebuild and develop Northern Province, which will cover the construction of the rail track and highways connecting the North and the South, while schools, hospitals and government offices will also be renovated and modernised.

The initial necessary financing to implement these projects have already been allocated in Budget 2009. They will be financed through concessional foreign loans, grants and domestic resources.