The nightly curfews ended on the last Sunday of June. A little over a month earlier, Sri Lanka lifted a two-month nationwide lockdown to contain the spread of the COVID-19 global pandemic. In this, it was successful. The island reported 11 deaths from 2,037 cases, of which 1,700 recovered as at end-June 2020.
More than half a million people died worldwide from the coronavirus which originated and spread from Wuhan, China. “The recovery will be w-shaped,” says Dimantha Mathew, Head of Research at investment house First Capital. “For now, the economy is still in decline after covid-19 and the worst is yet to come.” Sri Lanka faced what some are calling a ‘Catch-19’ situation. Tough lockdowns and social distancing rules will save lives but also destroy livelihoods. The government opted for tough containment.
However, it realised the impact on the economy was severe. It forced the banking sector to bail out struggling businesses, and by extension households. The government declared a moratorium on bank loans, the Central Bank allocated Rs150 billion for COVID-hit businesses and said it will guarantee credit extended by banks. Bankers responded with enthusiasm. They saw it as a national duty. But they were also concerned.
BLOODY SEPTEMBER
From the start, the details of the moratorium were cloaked in ambiguity. Nearly all borrowers rushed to avail themselves of the moratorium. Many believed their bank loans would be interest-free for the duration of the moratorium, but soon, they discovered that they would have to eventually pay interest that accumulated on loans during the moratorium period.
Banks are charging 7% interest, and finance companies around 11.5%, on loans during the moratorium period which borrowers do not have to pay. However, the interest will accrue and be capitalized as a fresh loan, or be included into an existing loan, to be paid after the moratorium. Banks lobbied hard to ensure interest incomes from loans did not take a hit because they needed to pay depositors their interest.
Regulatory aspects of administering the moratoriums were ambiguous and the accounting treatment for non-performing loans provisioning only finalized towards the end of May. By then, more than a month after the lockdown, the banking sector was clear about the application of the moratoriums.
Nearly half of those borrowers who had applied for moratorium withdrew their requests once it was clear that they would be paying interest after all. Banks claim up to half their borrowers took up the moratorium ranging from two, three and six months, which is what the majority picked. After the six-month moratoriums end in September, businesses will have to start repaying capital and interest on their loans which would be extended for a further six months to make up for the moratorium.
On top of that, they will have to service the capitalized interest accrued during the moratorium.
“We believe the downturn caused by the coronavirus impact will continue till after September. There will be many businesses that will come out of the moratoriums worse off and may go bust,” says Mathew “As a result, unemployment will double from 4.8% as at end-December 2019 to around 10% as struggling businesses layoff staff or declare bankruptcy altogether,” he said.
Banks are working around the clock to prevent wholesale defaults and are keeping hawkeyed vigilance over borrowers who showed signs of stress even before the coronavirus. Bad loans were already rising in 2018 and 2019, two years which saw muted economic activity because of policy uncertainty and terrorism.
Banking sector NPLs were 2.5% in 2017 but then increased over the next two years to 4.9% as at end-December 2019. NPLs rose further to 5.1% in the first quarter of this year; it was supposed to be a recovery year, but then came the Coronavirus.
“Banking sector NPLs will peak at around 9.5% after September 2020, a 12-year high,” said Atchuthan Srirangan, an Assistant Manager for Research at First Capital.
But he offers some hope: NPLs will ease to 7% levels towards the end of the year as the economy rebounds. The Central Bank had relaxed rules for provisioning for bad loans. To explain, imagine a company with a term loan, overdraft and a credit card with a single bank. Earlier, if one of these defaultedby 20%, the bank had to provide for the company’s entire debt portfolio.
The Central Bank has lifted the limit to 30% as a COVID-19 relief measure. “This should understate NPLs, but the question is how long the Central Bank will keep it at this level,” Srirangan explained. Topline revenue, or net interest incomes in the case of banks, will decline and non-interest income fees and commissions will fall.
Banks are likely to report lower profits, and maybe even losses at smaller banks.
“We believe banking sector profits will decline by 30% from our initial earnings estimate for 2020. Compared to reported profits a year earlier, earnings will be 19% lower,” Mathew said.
PLACEBO EFFECT
There is cause for much concern. A cash-strapped government heading for an election in August is forcing banks to provide financial relief—the only lifeline—to COVID-hit businesses. With a recklessness born from desperation, the state was pushing banks and the entire financial system in harm’s way, it seemed to have confounded analysts. However, it turns out the moratoriums may not be a significant threat. Sri Lankan banks are relatively well capitalized and professionally managed. The sector can absorb a six-month moratorium, and it’s not as if they have been forced to forego any income.
They say a difficult problem is best dealt with by sleeping over it. For the duration of the moratorium, banks are doing just that it seems. Banks have curtailed new lending. An earlier anticipated mass outflow of deposits did not happen because people want to preserve what savings they have. With interest rates in decline, banks’ interest expenses will not balloon. For all these reasons, the pressure on margins is manageable for banks.
Borrowers classified as bad, or those businesses in trouble even before the pandemic and lockdowns, may not have been given the moratorium. Banks had the discretion to decide who would get the moratoriums. However, banks were generous given the scale of the crisis and the self-realization that they had a national duty to deliver.
The government, through the Central Bank, was also keeping tabs, just in case. But the moratorium is not enough to revive the economy. The Central Bank allocated Rs50 billion to be lent to banks at 1%. Banks, in turn, were supposed to lend these funds to vulnerable businesses at 4% for salaries and working capital. Two months of lockdown had ground economic activity to a halt. There was no revenue to pay wages, rent or utility bills. The worst-hit are small businesses.
You know how bad COVID-19 has been for small businesses when Sri Lanka’s largest companies like MAS Holdings and Brandix—both clothing manufacturers with factories in several countries and highest export earners—started announcing sweeping salary cuts and voluntary retirement options. These are some of Sri Lanka’s most sophisticated companies that built massive war-chests to face off global economic crises. But no one was prepared for the scale of disruption in COVID-19’s wake. Small businesses everywhere have difficulty accessing finance.
In Sri Lanka, however, the challenges are more pronounced. SMEshave paid 20% per annum as interest on loans over the last 30 years. Compared to half that rate in India, small businesses in Sri Lanka cannot build reserves to face economic slowdowns or unforeseen crises. While SMEs are the first to take the hit during an economic crisis, their importance cannot be ignored. Small businesses account for 45% of jobs and generate over half of Sri Lanka’s GDP.
In recent times, Sri Lankan banks have built sizable SME portfolios. However, most still borrow from subprime lenders or finance companies. Few small businesses had access to the Rs50 billion COVID-19 loan schemefunded by the Central Bank. Some businesses were taking the loan at 4% and investing in higher-yielding, fixed-income instruments. An exacerbated President Gotabaya Rajapaksa gave the Central Bank a public dressing down, prompting the regulator to fast track approvals and extend the package to Rs150 billion.
Banks were still reluctant to lend. They have stringent due diligence processes for lending other people’s (depositor) money. The Central Bank said it will guarantee bank loans up to 80% for small businesses and 50% for large businesses just to banks comfortable about lending. The Central Bank had cut banking statutory reserve ratios (SRR) for banks which generated excess liquidity in the financial system amounting to Rs200 billion.
The credit guarantee was for bank lending out of this excess liquidity. On top of that, if banks lend at 4%, the Central Bank said it would give banks a rebate of 5%, which means banks can earn 9% interest from each loan.
“Banks are unlikely to take a risk by being lax with credit evaluation despite the Central Bank guarantees,” Mathew argues. The second SRR in June cut was not necessary because the market was already in excess, there was no need to boost liquidity further. Now, even businesses with inherent risk profiles may want to borrow,” he said.
It is still too early to know if banks are lending on these terms. However, it is probably less risk for banks to invest their excess liquidity in the Central Bank’s overnight window at 5.5%, or even invest in government securities which likely the case as the 200 basis points decline in treasury yields in June suggests.
“Given the risk appetite of the banking sector, not every small business is going to have access to these credit relief schemes. Even if they do, it is not going to be enough to make a big difference,” Srirangan said. “Businesses need more long-term funding which banks are unwilling to do”. However, he is confident the moratorium, credit relief and guarantee schemes would have a positive affect.
“They would prevent the economy from reaching the very bottom. And of course, there is no denying that genuine businesses will benefit from the relief schemes as well,” he said. Mathew predicts the anticipated economic turnaround will gather momentum towards the end of 2020 and consumer credit will recover. “After September we will see business activity picking up and some recovery. Usually in a depression, once people lose jobs there will be new businesses created. There will be new entrepreneurs that will come out of this crisis, but it will take time. The recovery period could be from September 2020 to March 2021,” he predicts.
This is welcome news. However, getting back to normal also means Sri Lanka is on course for another currency crisis. But that would not be nearly as bad as covid-19.
BACK TO NORMAL
Sri Lanka is a twin deficit country where both fiscal account (a budget deficit) and current account (trade deficit) are in deficit. This leads to frequent currency crashes and balance of payments crises. “Every three to four years there is a credit crunch followed by a currency crash, because of our twin deficits,” Mathew says. Even before covid-19, the economy was stressed because of the twin deficits. “Long periods of putting off tough (fiscal) reforms has come to haunt us because now we don’t have the fiscal space to deal with the economic challenges caused by the pandemic,” said Anushka Wijesinha, an economist and an independent director at a bank addressing a webinar hosted by the Ceylon Chamber of Commerce.
Sri Lanka’s COVID-19 relief allocation which includes the Central Bank refinance scheme and cash disbursements to low-income households is estimated at less than 1% of GDP (compared to India 10%, Thailand 9.6%, Vietnam 3.5% and the Philippines 3.1%), according to Verite Research.
Sri Lanka government debt as a percentage of gross domestic is also the highest amongst these counties at 89% (India 72%, Vietnam 43%, Thailand 10% and the Philippines 39%). The Central Bank is holding the exchange rate steady and import restrictions are already in place to avoid any outflows during the ongoing battle with the coronavirus. The question is how long will the restrictions last?
With interest rates at low levels, a pickup in consumption and government borrowing is inevitable towards the end of this year. Falling tax revenue makes the government’s borrowing needs insatiable. This crowds up private sector credit and drives up interest rates. But if the Central Bank releases liquidity to meet tightening credit, that stresses the exchange rate. Something has to give.
The Central Bank cannot have low interest rates and a strong currency at the same time.
“The exchange rate has been held steady for a while now. The rupee has depreciated by 2.5% against the US dollar whereas other currencies in the region have seen bigger falls. I believe we are due for a sharp correction and June 2021 will be a critical period to watch,” Mathew explained. “However, that will not be as bad as the coronavirus impact.”