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The journey of Sri Lanka’s economy has been a puzzle for most part of this year as two crucial elections had dealt a severe blow to economic certainty. But as the year now draws to a close, the island’s economic direction seems to have become clearer.

The Budget 2016, which has been marred by a string of public protests, will be put up for its final vote today (19) in Parliament while on the external front, the much-anticipated hike in interest rates by the United States Federal Reserve, which had been the main cause of a depreciating currency and the depletion of foreign exchange reserves this year, finally materialized this week. In a wide ranging interview with Nation, the head of Sri Lanka’s Monetary Authority, Arjuna Mahendran explained to us the intricacies of the economy, the controversial budget proposals, the present status of the finance sector, the impact of the Fed rate hike on Sri Lanka and the way forward.

Excerpts of the interview follow;

Q: What is your analysis on the status of the economy at present given that the pace of GDP growth has somewhat slowed down this year. Statistics has shown that the economy has grown to 5.2% up to the third quarter of this year compared to a full year growth of 7.4% in 2014?
When the new government took over in January, people’s incomes were unnecessarily depressed because until then growth was funneled by investments into concrete and therefore money did not reach people’s wallets. On the other hand, with the exchange rate being overvalued, exports also slowed down. Then you had the EU Fishing ban coming into effect. So what the government did was to stimulate the economy by raising people’s incomes. So a public sector wage increase was given. Prices of essential commodities were reduced. People were given more spending power. So, by the second quarter we got a growth of 6.7% and the third quarter has increased by 4.8%. So in an economy, there is the exports side and the domestic side.

On the exports side, it was affected by things such as falling tea and rubber prices coupled with having uncompetitive exchange rate until September. So we had to rely on the domestic side to do the heavy lifting. Now going forward, the exchange rate from the 3rd of September this year has been made a market determined rate. So, now you would find that the exports typically take about six months to respond to favorable exchange rates. So we are expecting that by March next year, you would see the export performance improving and also the government is negotiating with the EU to give access to seafood exports. So with the United States also showing strong signs of recovery, garment exports also should improve.

So, now the consumer side of the economy is running. In fact, we were concerned about the car imports and that’s why we brought the macro prudential measures to specifically say that loans for the car imports should be reduced to 70%. The extent that the currency has also depreciated, imports had become a little expensive and that will be getting in control over the next two to three months. Then when exports kick in you will see that the external side of the economy starts improving. That has been lagging behind because of the exchange rate effect. So, I think by March next year, both domestic and exports side will be on an even keel and we should be able to achieve a growth of about 6% in 2016.

Q: What is the GDP forecast for 2015?
I think we should average about 5.5% by the end of this year.

Q: It has been reported that Paskeralingam and yourself were among the two key architects of Budget 2016. And as you know the Budget has been revised to a greater extent by now. Why did this happen? Was it due to the lack of consultations when it was prepared?
First of all, I must categorically say that the Budget was crafted by the Minister of Finance and his team in the Treasury. Of course, Paskeralingam as the Economic Advisor to the Prime Minister and I as the Governor, were consulted. But to say that we crafted the Budget is completely wrong. Definitely, I know the

Finance Minister put a lot of work into that and we should give full credit to him because he had a lot of problems. The external sector of the economy was very weak, his tax revenues were very weak, the VAT law had been a mess as there were 7 pages of exemptions in the VAT law and revenue as a % of GDP at 10% hasn’t been so low in the history of the country. So, he had a lot to tackle and the Budget was a result of wide ranging consultations. I don’t think it is correct to say that Budget was not consulted because he met up with all the Chambers. He is one of the most dynamic Finance Ministers we have ever had in the history of this country in terms of the energy he brings into the job.

Q: Then why have we had protests against the Budget proposals on a frequent basis?
Now if you ask yourself what the people are protesting about, you won’t have an answer. Actually, this is political. Now you look at the bank strikes. They were among the two state banks. None of the private banks participated. All the private banks were fully functional. Now that tells you one thing – that the Ceylon Bank Employees’ Union (CBEU) was only able to get some government servants in the state-owned-banks to support their strike. Still nobody has articulated the reason why they are striking and to me it looks like some kind of a protest by people who are against Maithripala Sirisena’s Presidency.

Q: But the protest is estimated to have been attended by over 10,000 employees, which is a huge number?
Well, the state-owned-banks must be having about 20,000-30,000 employees and remember, a lot of these people were hired by people in the last regime and their loyalties are with that regime. So if you look at it in that perspective it doesn’t seem that the entire general public is against the government. This was just people who were given jobs by the previous government – who had their sympathies in that direction and are trying to disrupt the economy. But to this date, I have not heard what their complaint is! What they are asking for and what their main demand is! They just went on strike.

Q: Coming back to the Budget, could you please explain the rationale behind a few proposals. Why has there been a leasing ban on banks?
It is very clear. As I told you, this year we have had a problem in the leasing industry where the leasing industry has all gone into small cars. This was partly due to the duty concessions given to these cars in the Interim Budget by the new government and we have had massive increase in this small car category. The issue is we found that there had been irresponsible lending by the banks and the leasing companies and it was trying to become a bubble and we tried to prick that bubble. And, the Finance Minister has told the banks, you all must act responsibly. Because banks are large with huge capital and they cannot get into this type of speculative activity. There is a report now that the secondhand car dealers now have a stock worth of US$ 1 billion of unsold cars in the country.

So this was a huge problem in the industry that if these cars are not sold, cash is going to be locked up and this will be a problem to the whole economy. So banks have been told not to lease small ticker activity like cars. But if you are going to lease something like aircraft, that is possible. So I think that is the intention of what the Finance Minister did. For finance and leasing companies, leasing is a big part of their business while banks can do other type of business and easily compensate like concentrate on lending to SMEs, etc. So for the Leasing and Finance Companies, he (Finance Minister) said they can continue but we will try to control it with these LTVs (Loan to Value). So you must read the overall picture and not look at the statement itself.

Q: Why has the Budget imposed restrictions on cash withdrawals by imposing surcharges for those above Rs. 1 million?
That of course is being fine tuned but basically, the idea is that we have a problem with the drug industry in this country. Narcotics and all sorts of illegal items are being sold. So the idea is that we want to channel as much money into the legal sector, which means encouraging people to use cheques and route the transactions in the banking system. So we are trying to discourage this illegal economy, like arms, drugs, prostitution, etc. from being funded with cash transactions.

Q: The Budget has directed banks to expand their existing branch network by 15% by opening branches in under-banked areas and stipulated that these branches will have to employ at least 6 employees per branch. Since this rule applies even to private sector commercial banks, doesn’t this mean that government is interfering in private sector business and in effect could lead to hurting investor confidence?
That is an exhortation. The Budget is encouraging banks to expand and that is not a law. As far as under-banked areas are concerned, I have already a record number of banks asking me for branch openings. Banks themselves are seeing opportunities out there, but what the Finance Minister wanted to do was to advertise the fact that there is so much confidence in the banking sector now and they want to open branches. But at the same time, he (Finance Minister) wants banks to open proper branches and not just open branches like in Post Offices or in Supermarkets where only one/two person is employed.

For example, in Kilinochchi which has a fertile ground to grow passion fruit, what we found is that though there were people who wanted to cultivate given the agriculture potential, we found a lack of bank branches in that area. Even in the Western Province like in Kalutara South and areas in down South there were not enough branches there. Private sector opens only in profitable areas like in Maharagama where there is already competition and then we find there are five to six banks there, whereas in Kilinochchi you have nobody! The intention is to help the Small and Medium scale entrepreneurs and promote financial inclusion. In fact, I am going to open a separate department in the Central Bank to supervise financial inclusion activity. We are going to set targets so that every district/province has a target for branch openings.

Q: Why did the Budget propose to set a maximum cap on interest rates offered on deposits by finance companies?
Some finance companies when they get into difficulties, they start jacking up their deposit rates and then what happens is that even the good guys are then forced to raise rates to be on par with competition. Then you have the domino effect because one bad egg does it and others follow suit and then the whole sector will collapse.

Q: What is the financial status of finance companies at present? Some of them are reported to be under-capitalized with below the BASEL requirements. The previous government had set targets to adhere to minimum capital requirements and introduced a consolidation plan. But the policy is not clear with the new government?

In my view, this consolidation plan was not properly thought out. Look at the history of Sri Lanka and if you see the companies that have crashed, most of them are the biggest companies starting with Mercantile Credit which famously crashed in 1990s and then we had The Finance Company of the Ceylinco group which was the biggest finance companies for several decades. Those are the ones that were mismanaged – not the small ones. Look at the small ones, Central Finance, LB Finance, Alliance Finance-solid companies, perfectly run. Why? Because they are small and they are manageable and the managers know all the customers. When these fellows try to get too big, then they lose control and the whole thing collapses. Actually I would argue that the small companies are the gems, they are doing a good job. This consolidation plan where you think when you make people big, they are safe – that is rubbish! It has been disproved in the history of Sri Lanka’s finance company sector.

Q: Out of the 54 finance companies in operation, could you vouch that the status of each one of them is financially sound?
Some have problems but the majority of them are sound. More than 40 are perfectly sound. Anyway as the Finance Minister said in the Budget, we are going to ensure that all Finance companies are safe and sound. That much is certain. See in Golden Key now, we have found the money and we are paying. That shows our good faith as a government and as a Central Bank we are going to see that the finance company sector is properly run. There are some companies like I mentioned which has issues. But we will resolve them. We will find investors to put money in and make them profitable once again.

Q: Does the finance company sector require a consolidation?
No, I would say the sector does not need a consolidation at this point. I want to go into each company and talk to the management and see that whatever they are doing is being done properly first and then later on we can consider consolidation once the system is stable. But what happened then was, they announced the consolidation plan before fixing the problems that were already there. That was dangerous because if you put a bad egg into a pudding, it will make the whole pudding rotten.

Q: How practical is the Budget proposal for the Central Bank to guarantee finance company deposits given that the assets in the Bank itself is estimated to be a mere Rs. 82 billion while cumulative liability of finance companies are to the tune of Rs. 400 billion?
In the Central Bank, we have the Deposit Insurance Scheme in which finance companies and banks pay a premium. That fund is growing all the time and so far we haven’t been able to use it and is readily available. Going forward, I think the Minister wanted to underscore that since people are worried about these Ceylinco Group and Golden Key, he wanted to make it clear that the new government will ensure good governance by cleaning up the entire system. We’ve moved away from consolidation. No stress on anybody to raise their capital to unrealistic levels and we are only going to run a system on a sound basis. That is the message we want to give the people.

There is an example for this. In 2008, when we had the Global Financial Crisis, both Singapore and Hong Kong guaranteed that they would pay their deposits in those banks and that protected the two cities from any panic.

On your question of the mismatch between assets and liabilities, as I told you, more than 90% of the finance companies are safe. They are doing good business, profitable and they are okay. So maybe less than 10% have issues and we may need the money to back their business which we already have enough money in the Deposit Insurance Scheme to meet those liabilities. That is how you run a Deposit Guarantee. You don’t go and build a deposit to meet the liabilities of everything in the system. That is a waste of money to have such a large fund!

Q: But, by this blanket guarantee, don’t you think finance companies may be lured to take more risks which could then lead them to disaster?
Well that is our job. We will supervise them and if we see signs of excessive risk taking, we will hammer them very hard. I want to send that message loud and clear that the Central Bank today is a different entity to what it used to be. We are not going to be lax with anybody anymore and if anybody misbehaves they will be hit very hard.

Q: The IMF has recently warned Sri Lanka of an uncertain economic outlook, loose monetary and fiscal policies and urged appropriate action including structural reforms to safeguard economic stability. What is your opinion of their concern?

We are going to have discussions with IMF when they send their team next here. What we have already told them is Sri Lanka was in a situation of depressed demand because incomes were insufficient and there was excessive focus on government investment and that was sucking the financial resources away from the private sector, curbing private sector activity.

So the government has now a situation where the consumption can flourish and private sector also flourishes because the government will no longer be a big borrower in the financial system. In the past, government was borrowing so heavily crowding out the private sector. The shift entails that we need to spend something in the interim to boost the economy so that private consumers and private producers have money in their hands to spend more, thereby creating a growth impetus. The IMF has concerns that this will fan the flames of inflation in the longer-term but we will from the Central Bank ensure through our Monetary Policy measures that it will be kept in check and also from the fiscal policy front, the Prime Minister has said that he is targeting a 3.2% budget deficit by 2020. So if we keep to those targets, we know the concerns will die down.

Q: Finally, what would be the impact of 0.25% rate hike by the US Federal Reserve on Sri Lanka?

Throughout 2015 we have seen that capital has been flowing out of Sri Lanka. The foreign investors have been pulling money out of the stock and the bond markets. The good news, however, is that few months after the stock market came down, we have seen some foreign investor buying but in the case of bond market, money has been going out.

The simple reason is that there has been capital flowing out of all emerging markets and this is not only for Sri Lanka – India, Pakistan, China, Bangladesh, etc.

Why? Because their currencies are falling against the dollar. Why is the dollar getting strong? Because, markets had been anticipating the rate hike. So in that situation, Sri Lanka is a very small country and we can’t resist that type of force where all emerging markets are seeing a drain of capital.

So that’s another reason why the Prime Minister had in Parliament said he wants some support from the IMF because if the outflow of capital continues for several months, even after the Fed hiked rates, our remittances and exports will have to be the key. So eventually, I suppose that the IMF itself will realize that they will have to stand by us if we get into difficulties.