An insight into Sri Lanka’s economic behaviour

• Nations Trust Bank Executive Vice President – Treasury and Investment Banking Indrajith Boyagoda shares his views on Sri Lanka’s current economic circumstances and the role of banking in this environment

Q: Sri Lanka is currently facing some disturbance from an economic context. In your view, what has caused this?

To understand the current economic context, it’s necessary to look at the global economy from a macroeconomic perspective. The present turmoil is nota ‘Sri Lanka only’problem; it’s a regional and even a global phenomenon. Emerging markets (EMs) in particularweresubject to substantial stress a few months back even while developed markets (DMs)were facing some structural challenges such as fiscal related stress in Italy, theBrexit related challenges in the UK and Sino – US trade war to name a few.

In brief, Sri Lanka and other EMs are impacted due to substantial net outflows of funds particularly to the US; the most visible effect of this phenomenon is the pressure on the country’s exchange rate. Most EM countries run trade and current account deficits. Their exports comprise mostly of primary commodities or low value added price elastic non-essential goods and services, while imports are quite substantial, price inelastic, mostly essential goods.These countries also attract portfolio investments as againstForeign Direct Investments(FDIs). This combination results in structurally weak economies subject to negative implications of global volatilities.

The recent political uncertainty that destabilised the local economy on top of such global volatilities exacerbated the situation causing excessive volatility in the local market.

 

Q: What is causing this volatility?

There is a fundamental paradigm shift currently going on in the world, geopolitically and economically. Governments in countries like the US, UK and some other EU countries are challenging China’s dominance and becoming increasingly nationalistic. For decades till now, China and the Asian region as a whole have been considered as the production centres of goods and services whereas the US and the western world have been considered the consumers. But now, the US and other western nations are questioning this status-quo to bring home some of the production activities.

This is creating instability globally, in a system that had reached equilibrium for some time. Now that the balance has shifted, the system is trying to reach equilibrium again and the current financial crisis that Sri Lanka and other EMs are facing is partly a result of this shift.

After the Global Financial Crisis (GFC) in 2008/2009 when the world economy was almost at the brink of collapseDM countriesslashed interest rates to near zero or evennegative in some cases,releasing liquidity into their markets through Quantitative Easingto encouragean unprecedented level of consumption to revive their economies. The resultant excess liquidity coupled with near zero interest rates in home countries led their way to EM countries (such as India, Indonesia and Sri Lanka etc.) which still had attractive interest rate regimes.

This massive foreign capital inflow into EMs, boosted our economies. However, in most cases, these funds came in asPortfolio Investments (PIs) rather than Foreign Direct Investments (FDIs). This is very significant and is a major underlying cause for today’schallenges.

Q: What is the difference between Foreign Direct Investments and portfolio investments and how do they affect economies?

FDIs are Foreign Direct Investments used for productive purposes;i.e. to build manufacturing plants, or setup businesses. Theywill be longer term investments which will contribute towards real productive economic activity and growth that would result in production capacity expansion, increased trading activities and higher employment opportunities etc.

Portfolio investments on the other hand usually flow into a country’s capital markets to invest in financial assets such as government and corporate bonds, shares etc. These funds move fast, and can be in and out of a country in a flash; there’s no commitment or loyalty when these funds are invested. However, they boost the reserve position of a country and improve liquidity in the shorter term. They also have demand supply implications on both exchange rate and interest rate of a country. Drastic movements of these flows create substantial disruptions in countries if such economies are not structurally robust.

As noted above,a majority of EM economies are not structurally robust and subject to extreme volatility in the event of a mass exodus of Portfolio Investments. This can affect a country’s ability to manage its economic activities.

Post GFC, the capital moved freely into portfolio investments in Sri Lanka and other EMs through the investment activities of hedge funds and other wealth management funds.The moment a better opportunity presents itself, this capitalflows to the more opportune areacausing volatility as seenduring the past few months. The fact that these funds are moving capital out of EMs doesn’t necessarily mean our markets are bad, but better opportunities have presented else ware.

Q: Could you elaborate more on why portfolio investments are being withdrawn from Sri Lanka and other emerging markets and also how this impacts exchange rates?

Portfolio investmentsare done based on risk/reward models and when the rewards in low risk markets are acceptable, the investments move in such direction. With certain geopolitical changes that favour the US coupled with productive bases shifting back, employment numbers improving, strengthening USD, etc, the sentiment in the US has changed to the better and the resultant inflation has warranted US interest rates to be lifted from near zero levels. With interest rates continuing to increase, large portfolio investments are moving back from EMs to US.

 

Q: How can we remedy this, going forward?

While we shouldn’t discourage Portfolio Investments, more attention should be on FDI build up which would insulate us against crises when global capital flows adjust themselves in the future. 

Portfolio investments do provide near term economic benefits such as increased capital markets performance, strengthening LKR and increased foreign reserves. But their contribution to long term sustainability is questionable. To put it simply, the difference is similar to someone having money in their wallet; yes, there is money but what is the source, savings or proceeds from a loan? FDIs are like savings and Portfolio Investments are like loan proceedsand we all know which is better!

Q: Apart from this, what steps can the country take to mitigate and overcome this crisis?

One of the mainweaknessesin our economy is the underperforming export sector. For over two decades there had not been a proper national programme to boost our exports. It’s not just about building factories or signing Free Trade Agreements (they too are needed), but it’s also about how to attract entrepreneurs in to export industries. There should be a well structured national program to adequately recognise contribution by exporters to the national economy. Perhaps, through mechanisms to reduce the cost of production, preferential tax structures, development of infrastructure and logistics (targeting exports), efficient custom procedures, labour market skill and capacity build, competitive exchange rates, consistent policies, identification of new markets, stringent regulations to eliminate malpractices by exporters that adversely impact the country’s brand image and FTA concessions, etc. These need to be supplemented with well negotiated FTAs which open up markets for exporters.

Furthermore, the country needs a national plan (and execution) not only for exports but also for the entire real external sector, to boost foreign inflows to build healthy external reserves, which is imperative for stable growth and economic performance. 

Q: Could you elaborate on these?

External sector of the real economy is one of the most important areas for a stable economy and is not only about exports. Sri Lankans employed abroad or even local companies operating offshore are part of this ecosystem. Additionally, service industries such as BPOs and tourism that receive income from abroad plus foreign direct investments contribute immensely to build reserves and stabilise the external sector of the economy. 

In my view, exporting cheap blue-collar labour is detrimental to the country in the long run. Instead, similar to some of the regional countries i.e. Philippines or even India, we should have a proper skill/knowledge development program to produce skilled/white-collar labour that are demanded by the world labour markets. 

In the tourism sector in particular, there should be a broad understanding of the categories of tourists who would be attracted to Sri Lanka, their expectations and fulfilment of the same and a national plan to enable the related infrastructure development. In general, stable/favourable policy framework, efficient/professional administrative mechanism for establishment of businesses, favourable positioning in ‘ease of doing business,’ high quality infrastructure, stable political and policy framework etc. are some of the key enablers to attracting FDIs. Providing the aforementioned with a clear strategy is the sole responsibility of any government.

Though there is some work being done on the above areas, the need of the hour is a cohesive national strategy with the required level of urgency to deliver the benefits to the nation at the earliest.

We mustn’t forget that the rest of the world is moving much faster than us and if we don’t capture the opportunities when available, we will be left behind, just like it has happened in the past, i.e. Bangladesh, Vietnam, Maldives and some of the East European countries which started their development programs much later have already overtaken us.

In the absence of a strong external sector, the country depends on foreign borrowed funds for development and even consumption purposes. When such external borrowed funds are not channelled properly for suitable development activities it results in structural weaknesses which get amplified with events in the global economy.

Q: What should the banking and financial sector do in this environment? What are they doing?

In times of stress or structural weaknesses in the economy, lenders have a responsible role to play in their core activities.

Sometimes when there is high competition in the market, lending criteria could become somewhat relaxed. Also price competition could push rates down even below a sustainable level and borrowers could be given quite flexible financing. This was experienced in the western markets during the period which lead up to the 2008 global crisis. Cheap and excessive general purpose funding could entice borrowers to venture in to areas outside of their core competencies eventually leading to bad credits.

Furthermore, sectors which are booming due to speculative forces rather than the underlying economic strength are also considered red signals.These are some of the factors lenders should take note of in their credit decision making. Another area of attention is the sectors that are not necessarily supportive towards stressed economies (or in the contrary) exacerbate the existing weaknesses i.e. excessive luxury imports during periods of external reserve stresses.

While some of the above aspects need to be addressed, managed and controlled through policy intervention, there are others that need more prudent lending practices by lending institutions.

In my personal opinion, as an industry, we should collectively work towards building a business model that promotes and supports the broader economic strategy of the country. That way, I believe the banks truly become partners of the economic development of the country. At Nations Trust, we have various portfolios and we pay a lot of attention to SMEs and corporates. In the past, we were skewed towards consumer business but now we are more balanced in our portfolio that is more sustainable.

Q: What about sustainability and environmental factors? What direction should the industry take and what is Nations Trust Bank’s stance?

Environment and its protection for the future is a shared responsibility of all of us. As providers of capital to businesses and entrepreneurs, the banking industry can play an effective role by ensuring that the businesses are operated in an environmentally friendly and sustainable manner especially by restricting the borrowers and not allowing them to engage in environmentally damaging activities. At Nations Trust Bank we are committed to this aspect and have established processes to ensure the Bank does not lend to activities and sectors that are detrimental to the environment.

However, for this to be an effective process, the entire industry should adopt this concept into their lending practices so that as a whole, no funding will be made available to such destructive activities.

Q: Would you say that the present economic crisis faced in Sri Lanka is a shared responsibility by all?

 Performance of an economy is a result of the action of all the stakeholders in the economy. Be it the policy makers, policy implementers, buyers, sellers, businesses, customers, producers, consumers all of us are stakeholders in the economy and our activity will have implications (positive or negative) in the overall economy. Every individual in the society will fall in to one or more of the above categories. 

In very simple terms, as consumers, if we demand more foreign made goods and services than what the country can afford, it will have a direct implication on the external reserves and exchange rate. Similarly, if as consumers, we demand more goods and services than the country’s production capacity, that would result in inflation and eventually higher interest rates. If we do not pay our taxes, the government would not have sufficient income to spend on economic development. 

As voters, if we select the wrong policy makers and implementers who then formulate inappropriate strategies, the country could become structurally weak and expose itself to crisis. As you can see, economic health of a country is a shared responsibility that exists at all levels.

Q: Do you think people should try to become more economically aware and educated?

If I may take myself as an example, I come from a science background. My first degree is in chemistry, that thought me logical reasoning and to look at all actions from a ‘cause and effect’ point of view.Subsequent exposure toeconomics (plus exposure to the financial world) made me aware of the workings of an economy to understand easily, the cause and effect relationships of each economic activity that we perform in society. Therefore, I’m a firm believer that all of us should have reasonable exposure to ‘economics’ (as a subject) that will enable us to see through things more clearly and have less of a chance to be ‘hoodwinked’especially by the policy makers. Economic knowledge enables us to differentiate such policy makers’ inanity of short term vibrancy vs wisdom of long term sustainability.

Q: Final thoughts you’d like to share?

The average person in Sri Lanka, i.e. a person living a modest life in a rural area may think that, whether the dollar is at Rs. 150 or Rs. 185probably doesn’t affect him, or for that matter, he is indifferent to the interest rate being at 10% or 15% because he neither saves nor borrows!

Take this completely unrelated example: we are an import dependent country even for our road infrastructure. Most of the inputs for a well carpeted road are imported. Amongst other factors, depreciated LKR would increase the cost of building a good road that would improve the standard of living of that modest person who is not exposed to the financial markets at all. But the exchange and interest ratesamongst other factors) impacttheir standard of living (a carpeted road or a dust filled gravel road).As can be seen, we all are affected by economic factors (and their volatilities) in ways that we never ever imagine.

Economics is not a very difficult subject to understand but its contents has far reaching consequences in our day to day lives. Whether we like it or not, we all are impacted by it and therefore, those of us who learn about it and understandthe principles (and cause and effect) will hopefully,have a more responsible behaviour towards overall society.