RAM reaffirms Construction Guarantee Fund’s BBB+/P2 ratings

RAM Ratings Lanka has reaffirmed the Construction Guarantee Fund’s (“CGF” or “the Fund”) respective long-and-short-term financial enhancement ratings at BBB+ and P2; the long-term rating has a stable outlook.

The ratings are supported by the Fund’s very strong capitalisation and stringent underwriting standards, as well as the expected financial support from the Sri Lankan government, albeit with a lower degree of importance than other state-owned financial institutions. However, the ratings are pressured by the Fund’s weakening financial performance, small size and inherent dependence on a single sector.

Moreover, as a government-owned entity with an economic objective, the Fund may also lend to other government institutions. CGF was formed by the Government of Sri Lanka (“the Government”) in 1999, to play a strategic role in the construction industry by providing indirect financial assistance to construction contractors. However, the Fund is viewed to rank lower in priority than larger state-owned financial institutions within the Government’s overall economic framework.

Meanwhile, the Fund has been allocated LKR 100 million of seed capital, of which LKR 55 million has already been disbursed to it. CGF differentiates itself from banks and insurance companies that also provide similar guarantees, by not requesting collateral and charging lower fees, thus exposing itself to higher risk levels. That said, the Fund’s claims experience has been commendable owing to its stringent underwriting standards. Contractors requiring a guarantee from CGF must be registered with the Institute of Construction Training and Development (“ICTAD”). ICTAD grades each contractor based on its financial capability and past performance; given ICTAD’s strict requirements, only around 38% of local contractors have obtained a grading. In addition, each application is vetted by an experienced team within CGF to ensure that the contractor has the ability to perform the contract. Moreover, most contracts are monitored regularly to ensure that the contractors are within the requisite specifications.

We note that the Fund’s income is related to the expenditure of the Road Development Authority (“RDA”), which has employed roughly 70% of the Fund’s contractors in the recent past. In FYE 31 December 2010 (“FY Dec 2010”), the Fund’s premium income continued trending downwards, clocking in at LKR 31.55 million (FY Dec 2009: LKR 33.93 million); this was because many large-scale construction projects funded by foreign governments do not require guarantees. Given its lower premium income and high overheads, the Fund’s net underwriting profit contracted 24.43% year-on-year (“y-o-y”) to LKR 14.25 million in FY Dec 2010.

CGF incurred a pre-tax loss of LKR 15.28 million in FY Dec 2010 due to loan-loss provisioning — a prudential measure by the management to provide for a loan given to another state-owned organisation; the loan had been fully provided for by end-February 2011. However, the management has taken steps to recover this loan; we expect it to be recovered over the medium term, through the Government’s intervention. In the short term, CGF’s financial performance is expected to be pressured by claims and provisions. However, any deterioration in its financial performance beyond our expectations may lead to a downward rating revision. Likewise, the ratings could be pressured if CGF were to be directed to provide further loans to state-owned organisations, to the extent that they result in further losses and capital erosion. Despite its losses, the Fund’s capital adequacy has remained very strong. CGF’s capital adequacy ratio (“CAR”) stood at 63.03% as at end-FY Dec 2010 (end-FY Dec 2009: 60.83%). Prospectively, we estimate the Fund’s CAR to only descend to 55% with continued provisioning and crystallisation of claims. In addition, we note that the Fund can readily tap the remaining LKR 45 million that the Government has allocated to it, should the need arise.