By Sri Lanka’s private sector credit growth slowed to 2 percent year-on-year (YoY) in June 2014 despite the record low policy rates and low inflation. However, Sri Lanka’s gross domestic product (GDP) continues to grow at a healthy space as the first quarter (2014) GDP growth reached 7.6 percent on top of a 7.3 percent growth achieved in 2013. Usually, low interest and low inflation encourage credit, which in turn stimulates GDP. Slowdown in credit also hints possible slowdown in economic growth, which appears to be a growing concern for the Sri Lankan policymakers currently.
WHY IS CREDIT GROWTH SLOWING DOWN?
Several recent press articles on this subject have highlighted possible reasons for the slow credit growth. Dushni Weerakoon, an Economist at the Institute of Policy Studies, is of the view that Sri Lanka’s recent GDP growth was mainly driven by non-tradable sectors (with strong state involvement) and these high-growth sectors have limited capacity to absorb credit, resulting in the sluggish demand for credit. Another reason highlighted by her was the frequent monetary policy shifts from - “contractionary” policies to “expansionary” policies.
She points out that policy shifts during the recent past were too quick and did not allow adequate time for the banking system to recover from previous credit booms, thus, resulting in slower credit growth subsequently. Since 2007, Sri Lanka has had two instances of major policy interventions to curtail credit booms - in 2009 and 2012 - and Sri Lanka sought the International Monetary Fund (IMF) support during both these instances. (The Credit Dilemma: Monetary and Financial System Stability in Sri Lanka, May 2014).
In an article written by Deshal de Mel, an Economist from the private sector, highlights that the drop in gold prices consequent to the reduction of quantitative easing by the US as a major cause of slowdown in credit growth in Sri Lanka. He shows that 27 percent of credit growth during the credit boom between 2010 and 2012 was driven by pawning advances. He opines that Sri Lanka may not experience credit expansion similar to what was witnessed during 2010-2012, which was driven mainly by easy consumption credit, backed by the rising gold prices. (The Unseen Impact of US Tapering of Quantitative Easing on the Sri Lankan Economy, April 2014). Credit to the private sector grew by an average 27.4 percent during 2010-2012, partly due to a surge in business and consumer confidence following the end of the three-decade civil conflict in 2009.
Meanwhile, Central Bank in its recent periodic monetary policy reviews also stresses the impact of pawning advances has a major impact on credit growth. Drop in gold prices has not only increased non-performing loans of banks but also cut new pawning advances. The Central Bank also says the slowdown in credit growth is a temporary phenomenon partly due to the lag effect in transmitting of low policy rates to the financial system.
Despite the growing concern whether decline in credit growth may curtail GDP growth, Sri Lanka’s recent experience is consistent with the findings of a study published by Bank for International Settlement (BIS Paper 416, Credit and Growth after Financial Crisis, July 2013). This study shows that there is no correlation between the private sector credit growth and GDP growth in post-debt-driven macroeconomic distress situations like what Sri Lanka experienced post-2009 and 2012.
This report highlights that the GDP growth subsequent to policy interventions to curtail credit booms mainly comes from increase in competitiveness due to adjustments in the exchange rate. Sri Lanka’s data also suggests that in the last two to three years, the GDP growth was helped by strong exports. Nevertheless, this study stresses that the relationship between credit expansion and GDP growth becomes significant after two years of such policy interventions, which indicates that continued credit contractions may curtail future GDP growth in Sri Lanka. It is possible that slow credit growth in Sri Lanka is due to a multitude of factors in addition to factors highlighted above and it is important to analyse this from different perspectives – especially from the perspective of the borrowers. We must ask the question, “Is there a big need for bank credit? If so, why aren’t companies borrowing?” Companies may be reluctant to borrow for various reasons such as anticipated decline in future business activities, preference for alternative funding or even due to companies reaching their borrowing capacity.
Sri Lanka Enterprise Survey conducted by the World Bank/IFC in 2011 shows that only 25.1 percent of businesses surveyed said that they are not in need of a loan. This is lower than the regional average of 40.3 percent and world average of 43.9 of percent firms saying that they do not need a bank loan. We must not forget that the 74.9 percent of firms were in need of a bank loan during the period of last credit boom. This is despite Sri Lankan businesses showing very high level of leverage compared to region and world (in 2011). This survey showed that 35.4 percent of investments made by Sri Lankan businesses were financed by bank borrowing – higher than the regional average of 20.4 percent and world average of 14.9 percent. Hence, it is possible that the show down in credit growth is not necessarily due to lack of need of funding but partly due to the existing high level of leverage.
SOME VIEWPOINTS OF BUSINESSES/ENTREPRENEURS
As a private equity (PE) investment firm, we get the opportunity to meet different types of companies – of varying sizes and in various industries. Although most businesses which come for our services have already made a decision to raise equity instead of debt, we always ask them “why they want to raise equity and not debt, especially when interest rates are low.” Many companies seek equity funding as they do not have the capacity to borrow further or do not have assets to mortgage.
However, our observation is that some companies, which seek equity funding, can easily secure bank credit. Reasons some of these firms give as to why they opted for equity funding may shed some light into current thinking of businesses/entrepreneurs and may provide some hints as to why credit is not picking up as policy planners are anticipating. Given below are some of commonly highlighted reasons as to why companies prefer alternative funding like PE instead of bank credit.
“We are not sure if interest rates will remain low.”
Although currently Sri Lanka enjoys very low inflation and low interest rates, many companies/entrepreneurs believe that interest rates could move up again in the future. Some borrowers have experienced shocks of such policy changes in the past (especially those who borrowed on floating rates) and hence, when they borrow for new projects, which are medium to long term in nature, they always consider the possibility of a rate hike in the future.
This point also relates to much broader concern about policy uncertainty in Sri Lanka, which has been identified as a major concern for private investments. A recent review of Sri Lanka’s economic performance by the IMF also notes that a revision of policy rates may be required if inflation picks up.
“We are growing fast; banks want more securities for additional loans (and we don’t have anything more to mortgage).”
Our observation is that many firms (especially small and medium enterprises (SMEs)) have not been able to strengthen their balance sheet due to the high level of borrowings in the past. Many firms were started with very little (initial) equity capital and most of the cash generated by such businesses has been absorbed by lenders. When such businesses ultimately graduate to next growth cycle, they often find it tough to borrow further despite some having very stable businesses.
We have observed some instances where companies with very stable businesses and cash flows are unable to borrow due to lack of assets to mortgage. The current bank lending system is not geared to accommodate lending for businesses based on the merit of their business prospects. Although there are SME lending programmes, which provide credit without collateral, such lending programmes appear to take into account a “viability” of the business as opposed to “growth potential” of a business.
“Interest rates are still too high.”
It is important for banks to make profits for the stability of the financial sector. However, many Sri Lankan banks have been reporting large profits with fat interest rate margins in the recent past. Some informed borrowers often point that banks are not passing the benefit of low policy rates to borrowers, which discourages borrowing.
Even a recent report by Standard Chartered Bank (July 2014) highlights that Sri Lankan banks are only passing the benefit of low interest rate to their top-tier/prime customers. The Central Bank data shows that the average weighted bank lending rate as at end of June is 13.8 percent, compared to three-month treasury yield of 6.5 percent at that time! However, with the sharp drop in treasury rates during the last few weeks, banks will be compelled to increase lending to sustain their operations, which may create more conducive market for borrowers.
“We want to go public, (and we think we have better businesses than some recent IPOs).”
It is encouraging for PE firms like us to note that there is growing interest among businesses to go public. Such firms naturally consider replacing debt with equity from professional investors from early stages to build a good track record of profit and to build a good balance sheet. Even though this trend will not have a significant impact on the overall credit growth, more and more firms seeking alternative funding may have some long-term implications on the credit and capital market.
The increase in listings by many firms in the recent past - especially small firms and also some firms without much track record - has encouraged many firms to consider listing. Fortunately, many such firms are not rushing into the market, but opting to take the proper way of improving themselves with PE before going for a listing.
It should be noted that the above views are expressed by a small sample of firms (though coming from diverse backgrounds), which have already decided to seek alternative funding like PE, and by businesses which envisage growth in business volume in medium to long term. We must bear in mind that the above sample excludes firms which are curtailing borrowing due to the slowdown in the anticipated business and also businesses which are doing very well (and hence, does not need any kind of funding).
Hence, the above views may not be a reflection of the boarder market reality. However, in conclusion, we can note that both policy uncertainty and the banks’ inability to pass the benefit of low policy rates to borrowers quickly have some negative impact on credit growth. Another possible cause for slow credit growth is lack of capacity to absorb further credit as indicated by views expressed by businesses and also by Sri Lanka Enterprise survey.
(Indika Hettiarachchi is the Managing Director at Jupiter Capital Partners)
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