Impact | Sundayobserver.lk

Vigilance on impact of volatile global financial market on domestic financial system:

The Governor Central Bank of Sri Lanka, Ajith Nivard Cabraal in an exclusive interview with Sunday Observer outlines the precautionary measures the Central Bank has taken to avert the country’s financial system from being adversely affected by the onset of the global financial crisis. The genesis of the global financial crisis is the collapse of the US Real Estate Market which is popularly known as credit crunch. It triggered off a crisis of faith in the Wall Street, plunging US into financial crisis with a magnitude that has not been witnessed since the great recession.

As the panic-stricken investors withdrew their capital, confidence in the financial systems virtually evaporated leading to the world’s emerging stock markets to plunge; in some cases losing half of their value and currencies shaken. The crushing halt in the credit market sent tremors as foreign banks suddenly stopped lending, including most basic services like trade credits.

Governments around world are putting up a hard struggle to limit the damages the on-set of global financial crisis would cause. Although the bail out packages are an easy way out for those countries with substantial foreign reserves, less fortunate countries are seeking help.

Q: It is clear that the world is heading for a recession. This will not only seriously affect the financial health of strong economies such as US, UK, Germany and European Union but also hamper the growth momentum in India and China. Against this backdrop, how do you asses the current global situation and the stability of major financial markets?

A: It may be noted that the roots of the present problems have developed over a long period of time around the home mortgage market in the USA. In today’s mortgage industry, home loans are often packaged together and converted into financial products called mortgage-backed securities. These securities were sold to investors around the world. However, there was no proper regulatory or supervisory framework that governed this mortgage-backed security market. Gradually, housing market bubble was created and it burst creating a problem in the financial market in the USA. As a result of gradual collapse of the mortgage market, many financial institutions began to incur huge losses. These institutions ran out of money needed to meet their immediate obligations, and they began to collapse creating a financial crisis across the international financial market. As you correctly mentioned, the current global financial crisis is affecting almost all countries including US, UK, Germany, the EU and also India and China, but with different magnitudes. Almost all central banks are responding to this situation by providing additional liquidity to markets through various measures to prevent any impending risk and also to restore confidence of the financial system. The financial system rests at the centre of all economic activities and interconnects such facts together. The financial markets such as money, foreign exchange, commodity, share, derivative, bonds, treasury bills, letter of credit, capital are interlinked. That is why the turmoil in the financial market is felt across all these markets, disrupting the activities of the different segments of the economy in different magnitudes and in different time frames. With the ongoing efforts of monetary authorities all over the world and the respective governments, the impact of financial crisis would not last indefinitely and my view is that the global economy would rebound in due course.

Q: Since America is a major trade partner, Sri Lanka would feel the tremors of the financial meltdown. Especially this would adversely affect Garment Sector as US is a major market for Sri Lankan Garments. How financial crisis would affect the Sri Lankan economy in general and Garment sector in particular?

A: Although, the ongoing financial crisis originated in the USA, now it has affected almost all the major financial centers around the world. Today, all countries are linked with each other owing to economic and financial integration. Therefore, not only the changes due to the turmoil in the USA but the crisis situation in other major markets too would impact the Sri Lankan economy to certain extent in time to come. The nature of the impact is mainly expected in the field of external trade across both exports and imports as trading activities are greatly involved with financial system, derivative trading, credit facilities, etc. For that reason, there may be some temporary drawbacks in the apparel industry as well as in other industries. With the dispersion of the current financial crisis, the international financial institutions who had large exposure to defaulted financial assets (mortgage-backed securities) began to incur serious losses and faced imminent collapse. As described above, the financial integration transmits the losses to other financial institutions. Fortunately, Sri Lanka has only a minor relationship with the these institutions that have got into difficulties. Because of this reason, there will not be a significant direct impact on our economy that arisen from failed financial institutions.

Q: Is our financial system resilient to such a global recession? Has the Central Bank taken specific measures to secure the stability of the financial system?

A: Despite the individual and co-ordinated intervention by the major world Central Banks, the global financial situation continues to be uncertain and volatile. Therefore, it is incorrect to say that the Sri Lanka is completely immune from this crisis. However, continuous monitoring, precautionary actions and timely interventions by the Central Bank of Sri Lanka to ensure stability in the Sri Lankan financial markets has ensured that the Sri Lankan economy maintains stability and is able to withstand the current turbulence in global financial markets, with confidence. The most important thing was, building both the public and investor confidence upon the banking system. This was equally important as infusing greater liquidity into the system.

This was achieved through a series of temporary measures in addition to measures we have taken some time ago in the preparation of our economy to face any impending crises. Other than making a general provision of 1 per cent on performing loans and advances, the Risk Weight applicable for Housing Loans was increased from 50% to 55% in November 2006. A limit on commercial banks’ borrowing from abroad to 15 per cent of their capital is applicable. The Central Bank took measures to formalize and strengthen the banking supervision activities and to educate the banks on the management of risks. We also issued new far reaching and landmark directions on Corporate Governance, Limits on shareholdings, Maximum amount of accommodation limits, and enforced these new directions stringently. Internationally, the Central Bank invested its external reserves with highly rated international banks, basically with foreign Central Banks, and thereby ensured the 100 per cent security and safety of its own reserves. Even these invested in some commercial banks were withdrawn on this, before sharp collapse as the Central Bank has been continuously nominating these. We have opened the Treasury Bill and Bond Markets to foreign investors with carefully placed limits, while creating a buffer to meet any threat of a sudden capital flight. We absorbed an additional US dollars 622 million from the foreign exchange market, in the first 8 months of this year.

This has enabled the Central Bank to supply foreign exchange in a situation where there is a need to supply external funds into the market to keep it stable.

The Central Bank also relaxed the limits on access to its reverse repurchase window as well as reducing the statutory reserve requirement to provide additional liquidity to the market to alleviate any pressures that may arise due to the current situation and thereby ensure the smooth functioning of the domestic financial system by removing any liquidity constraints. Even in the future, the Central Bank would continue to monitor the conditions carefully and respond to the needs of the economy with suitable interventions, if and when any further interventions are required.

Q: CB has given license to set up Licensed Commercial Banks, Specialized Banks and Finance Companies. However, I believe that adequate publicity has not been given so the public is in a position to make sound investments. Even if the information on finance companies is available, people are often lured by unrealistic interest rates offered by some finance institutions and pyramid schemes. How can you rectify this situation and raise public awareness with regard to unscrupulous elements operating under the guise of finance institutions?

A: No one in their right mind can say that the Central Bank has not given adequate publicity about the dangers of placing of deposits in unauthorized financial institutions.

However, with the collapse of some organizations to mobilize funds from some members of the general public illegally, a few persons have made such allegations. Therefore, let me clarify the action taken by the Central Bank under the law in this respect, in order to set the record right.

Accordingly, the names of registered finance companies and licensed banks that are authorized to accept deposits from the public and carry on finance business, have been published regularly, in the national newspapers in all three languages.

During the last 14 months (July 2007 - Sept. 2008) alone, the Central Bank spent more than Rs. 14 million for these press notices. In addition, our figures reveal that the banks and finance companies registered with the Central Bank have themselves spent over Rs. 4,500 million on advertisements during the last two years, inviting the public to avail themselves of their services, including accepting deposits.

In addition, our officers participated frequently in educational programmes, discussions and talk-shows to educate the general public on the consequences of investing in unauthorised finance businesses.

We also published a brochure containing the facts that should be considered before making investment decisions that was printed in all three languages and distributed among the public through the Regional Offices of the Central Bank and the branches of Regional Development Banks and registered finance companies, island-wide. About 400,000 leaflets with more details were distributed throughout the country through the Grama Niladharies. A 15 minute special television programme, explaining how to select safe and secure investment schemes, was produced and telecast many times over the television. Media personnel were educated on the statutory and regulatory aspects in respect of carrying on finance business with special attention to unauthorized conduct of finance business, at a training programme conducted at the Central Bank’s Centre for Banking Studies.

In particular, Sakvithi House Constructions (Pvt) Ltd., and five other persons or organizations, were examined by the Central Bank to establish whether they were carrying on finance businesses illegally. In the course of investigation, on 19 September 2008, five institutions were simultaneously examined and the Monetary Board on 23 September 2008, having considered the reports submitted to it, determined that Okanda Finance (Pvt) Ltd., Nadini Finance (Pvt) Ltd., Sakvithi House Constructions (Pvt) Ltd., Sriyavi Homes Lands & Investments, Piyadasa Ratnayake (Danduwam Mudalali), and D. K. Udayasiri were carrying on finance business unlawfully.

Therefore, on 24 September 2008, in accordance with the Finance Companies Act (FCA), the Central Bank gave one month’s notice to all six institutions to fulfil all requirements under the FCA and register with the Monetary Board. This option is to be terminated on 24th October 2008.

In the meantime, the Central Bank has also requested media and advertising firms to be vigilant in publishing advertisement regarding unregistered finance businesses.

Further with a view to strengthening the provisions relating to action to be taken against unauthorized deposit taking institutions, amendments to the current Finance Companies Act were also proposed and have been already submitted to the Legal Draftsman. In our view, the majority of the investors in unauthorized institutions are fully aware of the illegality and/or the risk of the institutions in which they place such investments. The attractive rates, other returns and motives of tax evasion has led some persons to invest in these institutions, while some others may have chosen these illegal institutions over the legitimate deposit taking institutions, in order to hide from the authorities the illegal origin of the funds. The documents and agreements they have signed with the relevant institutions in support of their investments make this quite obvious. In most cases, the certificates issued acknowledging the deposits / investments are by no means similar to a fixed deposit certificate or an investment certificate issued by an authorized financial institution. This is also a clear indication of the objectives of both parties involved in the transaction. When persons knowingly enter into high risk transactions, they are responsible for the consequences that flow.

Q: CB recently has announced reduction of Statutory Reserve Requirements (SRR) as a move to release more liquidity to the market. The Central Bank also announced that this step has been taken as a measure to combat liquidity restrain that may arise as a result of on-going financial meltdown and impending global recession. What are the similar measures on the card to make financial system resilient to a crisis situation?

A: The proactive and forward looking changes to enhance the regulatory and supervisory framework by the Central Bank such as the implementation of Basal II, enhancing the capital requirement for banks and other financial institutions, increasing the risk weights on lending for Housing and Consumption related credit, have ensured that our financial system remains stable and resilient despite the turmoil in global financial markets. The Central Bank continues to be vigilant over the impact of volatile global financial markets on the domestic financial system. The Central Bank continues to closely monitor the balance sheets of all commercial banks, finance companies and specialised leasing companies in order to detect and rectify any anomaly which may arise in the future.

Q: Against this background, how far do you think our fundamentals of Sri Lankan financial system are sound? If the fundamentals are not so strong, would you recommend injection of capital into the system to combat a liquidity crisis that may develop in a global recession?

A: Fundamentals of the Sri Lankan financial system remain sound and stable and hence an injection of additional liquidity into the system to combat a liquidity crisis is not needed. The prevailing turmoil is likely to ease as several measures have been taken by major economies to make markets more liquid. In that context, the prevailing tightness in the domestic markets would also ease in due course. However, we carefully and closely monitor developments and will take any necessary remedial and precautionary actions without any delay if we so feel. In fact, foreseeing the potential spill over impacts of any global turmoil, the steps that the regulatory authorities in Sri Lanka have taken over the past two years to build “shock absorbers” within our economy to face such shocks are paying off today.

When the foreign exchange market was very liquid, we intervened in the market by absorbing foreign currency to prevent undue appreciation of the exchange rate, especially to build up our external reserve position as a buffer to withstand the oncoming shock. This buffer has helped us to prevent undue volatility of the exchange rate amidst severe pressures in the foreign exchange market.

As mentioned earlier, even before the sub-prime crisis was emerged in the United States, we imposed an additional provision of 1 per cent on all performing loans of banks. This move was highly criticized by many people at that time. However, now they have realized the rationale behind it and in fact they now appreciate the move. Weaknesses in risk assessment and management are considered the main cause of the US credit crunch. Knowing the repercussions, proper risk management strategies were put in place to avoid any adverse shock to our financial system. These measures are yielding results as our financial institutions; especially the banking system, operate without losses and erosions in capital.

We have taken and will continue to take appropriate measures to provide sufficient liquidity to the market without posing any threat to our monetary targets. While tightness in financial market liquidity is considered temporary, we have allowed banks to operate with the required liquidity by reducing the SRR and enhancing their access to the Reverse repurchase facility of the Central Bank even amidst the tight monetary policy stance.

As a result of all the measures taken so far, we have been able to withstand any pressures due to the global financial turmoil and maintain stability in our financial system without a major crunch.

Q: What are the measures that you envisaged to bring down inflation and to raise founds in foreign currency to bridge the budget deficit?

A: The Central Bank has adopted a tight monetary policy stance since end 2004 with a view to containing the rising inflation pressures in the economy. This stance was further tightened in 2007 with the Central Bank further restraining the supply of reserve money, the operating target of its monetary policy, and thereby allowing market interest rates to rise and make credit costlier for borrowers.

These measures were complimented by prudential requirements. For example, risk weights in respect of loans secured by a primary mortgage over residential property was raised. The prudential measures have also helped decelerate the growth in overall credit extended by banks.

The above steps taken by the Central Bank has curtailed the growth in domestic credit and thereby, the money supply, supporting the containment of demand driven inflationary pressures in the economy.

There are several ways of financing the budget deficit from foreign sources, which include concessional loans, grants, commercial borrowings and foreign investment in rupee denominated Treasury bills and bonds. The majority of foreign borrowings still consists of loans obtained from bilateral and multilateral lenders under concessional terms and conditions to implement development projects. However, access to concessional borrowing is in the declining path in the wake of reduced access to concessional borrowings with the increase in per capita income of the country. Hence, government had to gradually rely more on commercial borrowings to finance the deficit. In line with this, the government has taken a syndicated loan (commercial borrowing) of US$ 150 million so far in 2008 and has called interest of expressions to borrow another US$ 300 million recently. This structure of foreign financing is expected to continue in the near future as well.

CB ensures stability with precautionary measures and timely intervention

- Ajith Nivard Cabraal, Governor Central Bank