Central Bank looks at risk management structures and investment policy guidelines
Arjuna Mahendran, Sri Lanka’s new Central Bank Governor, was a senior economist at the bank before moving to the private sector and charting a successful career as a global investment banker and fund manager. Having served once as chairman of the Board of Investment under Ranil Wickremesinghe’s stewardship as Prime Minister in 2002-2004, the experienced economist is undaunted by the challenges ahead. In this interview with the Business Times, he discusses a range of issues including questions over his appointment while exuding confidence that Sri Lanka can grow with the right policies in place:
Was there a crisis in the Central Bank?
The new Governor soon after he assumed office.
There is no crisis in the Central Bank (CB) per se. what has happened is that the CB has expanded its role to being a player in the market which was unforeseen when the Monetary Law Act was conceived and executed in the 1950s
Now we find the CB actively running and managing investment portfolios for the Government, for the Employees Provident Fund (EPF) and for itself.
Is it a practice prevalent in other countries?
Singapore for example has the Monetary Authority of Singapore and that’s a different type of model as they have their currency board which is separate from the Monetary Authority. The Authority is a purely policy making institution and doesn’t run the reserves unlike Sri Lanka where we run the reserves. In that context it has a more, broader function.
We also perform an agency function for the Government, managing its reserves like the EPF and public debt.
Thus the CB in Sri Lanka is much more powerful that the typical model of the CB in terms of the diversity of activities that it does. That is why it is at the butt-end of a lot of criticism like for example the merger of banks and using EPF monies to invest in various avenues including the stock market. At the end of the day the CB has to pick up the tab (losses or profits) as that’s how the investments have taken place.
I won’t go into whether that model is good or bad. That is the model we have. However the control structure for these multifarious investment activities is something that I am certainly looking at very closely.
In all major international banks that I have worked in, there is a strong risk control function. These risk functions are usually independent of what is called the compliance function. The compliance department of a big international bank looks at whether they are complying with the laws of the jurisdiction in which you operate …
Meaning these two departments – risks and compliance should be independent of each other?
That’s right. The risk side looks purely at what kind of risks one should take in investments. We need to see whether we are properly controlling these risks.
For instance when the Greek bond issue came up, the question I ask was that why did the CB which is managing the Government’s reserves invest in sub-investment grade instruments. Such investments should not be made. We need to check whether the appropriate risk control managers were looking at that aspect.
There have been complaints to the anti-corruption authorities now on this.
Our priority is to take measures to stabilise the system. What we need is an investment policy statement. I am examining this now to see whether there was one and if so whether it was properly constructed.
The Investment Policy Statement lays down the guidelines on which risks are mitigated and how they are mitigated which may say you can invest in G7 currencies or investment paper … setting up strictures which then prevents the fund manager from taking unnecessary risks.
So were these in place and was there a proper policing authority to ensure those were controlled, needs to be examined.
That’s my first priority – risk management of asset investments.
Moving on … the CB’s key function is to supervise the banking sector, finance companies and all kinds of other institutions.
In the Golden Key issue, it appears according to a judgment by former Chief Justice Sarath Silva that the CB had absconded from its duty of ensuring that any institution involved in financing activities should be supervised. The CB appears to have taken the position that this was not a regular finance company and was only a credit card company that was taking excess credit card balances and paying interest on it. Thereby the CB absolved itself of any responsibility. The chief justice made a very clear point that the CB had flouted its responsibilities. These are issues that we need to look at – the finance company structures, the Golden Key and several other similar companies.
The process has begun and we are talking to the Attorney General (AG) to see whether we could prosecute certain people and I am optimistic that we can help the depositors at the end of the day.
When you say prosecute some people, are you referring to inside the CB and outside?
In the CB and also through the courts … which had appointed a depositors’ committee headed by Lakshman Watawala and now Priyantha Fernando which is running those institutions. We need to talk to the AG to request the courts on whether these companies should be kept alive or liquidated.
I want to accelerate those processes and give some clarity in having a pre determined procedure in which for example when a finance company is in trouble what steps should be taken, the parameters that decide its (unsound and if that happens what does it trigger .. for example do we need more laws, or should the CB take it over and run it, etc. There are many gaps in the law to tackle situations at the moment. Who carries the baby? Is it the depositors who appoint a board of directors or is this a court function or the CB. We are examining the laws in other countries to see whether we could make this process simpler and more transparent. At the moment is it very murky.
On the Golden Key fiasco, what kind of assurance can the CB give to desperate investors?
Firstly we need to clarify the law so that everybody understands the process. At the moment the process is very nebulous- that is the problem. The depositors are running around in circles, the courts are running around in circles and the CB is powerless o act because there is no guiding law.
In the early 1990s there was a problem with finance companies with many were crashing. The CB moved and took over these struggling companies, restructured them, paid the depositors and the issues were sorted out.
Since then the law has evolved to the point where the CB doesn’t have those powers anymore and as a result these issues become the problem of the depositors and the courts.
On the financial sector consolidation, one of the allegations is that some interested parties wanted to protect some unsound finance companies that were going to crash and this was a mechanism to protect them. Your comments:
Too early to say whether this is right or wrong. What I can say is that companies like Golden Key were huge within the financial sector. Thus no consolidation will help companies like this. On the flipside is that among banks, one of the reasons for the consolidation was to make the banks bigger so that they could go to the international markets and tap bond and equity funding. But remember even with consolidation – say for example the Commercial Bank and the HNB or DFCC and NDB combined are still too small in my view to really make an impact.
To me the only consolidation that would make sense is to merge the NSB and the Bank of Ceylon and then have a US$10 billion bank which is reasonably sized.
I worked for a $200 billion bank which was Emirates … in Dubai and we found it difficult to attract investors for our tier-1 and tier-2 papers. Anything less than $10 billion in the Sri Lankan context is not going to be even looked at. So from that perspective I question whether the DFCC-NDB merger will have much of an impact. Ideally a $50-100 billion portfolio is what the financial markets need.
So… what’s going to happen on the financial consolidation process?
The Prime Minister has appointed a committee headed by Dinesh Weerakkody with several bankers to examine this issue in depth. The CB will also make its own submissions and the committee will submit a report. But if the objective was to tap financial markets then it is not going to work.
We also need to ask the question as to why five years after the war Sri Lankan banks are not growing fast enough.
This is something that worries me. Is there something in the environment that is stifling the growth of banks? One factor would be that the foreign banks are creaming off the best business.
I worked for one of these foreign banks (which are located here) and I know for a fact that all the trade finance which is very thick margins of business – import and export – is dominated by foreign banks. What they do is to borrow in the wholesale market – local banks – fund a trade activity and make huge profits. They don’t have added costs of investing in a branch network. As a result the local banks like the People’s Bank are hamstrung by the fact that it spends most of its time funding massive bills of the Ceylon Petroleum Corporation. Thus they don’t get the space to finance those high margin international trade business from big exporters like MAS Group, etc or big importers. So their growth is also stifled.
We need to review the entire banking sector and see why banks are not growing faster. There’s no war anymore; there’s no excuse.
This is a concern I hope the committee on the banking consolidation will look at. To me it’s a chicken and egg situation; one can talk about consolidation but if the banks aren’t growing fast enough then we have a problem here.
I have also asked the International Monetary Fund (IMF) to send some technical experts to look at these issues from an international perspective and they have agreed to do so.
They would be looking at the financial stability of our financial system; how stable is it and what is impeding faster growth.
Last year during the drought profits of Sri Lanka’s big banks fell. That meant two things; the drought itself had an impact on agriculture and plantation crops while secondly there was a huge dependence on gold pawning activity. And because the price of gold had fallen the previous year, pawning activity froze. This affected credit growth and for the 12 months to September 2014 bank credit didn’t grow.
This was despite the interest rates coming down?
Exactly and the main cause for this was gold. This shows to a large extent that rural folk are keeping their savings in gold rather than in banks. Thus the cash economy hasn’t reached large parts of Sri Lanka. This is a very interesting lesson to understand how the dynamics work in Sri Lanka in that the outreach of our banking system is still insufficient. Another statistic that stunned me was that the bank penetration in the north after recent post-war economic developments is now higher than the Western province. More people have bank accounts in the North as a proportion of the population than in the West.
Why?
Partly because Northern residents have many relatives abroad who send money to these accounts. But the banks have also made a special effort to penetrate this market.
Both the Prime Minister and the Finance Minister are proposing that every citizen in Sri Lanka should have a bank account.
How would this be done?
Discussions will be held with commercial banks, micro finance and other financial institutions
Micro finance and finance companies don’t have access to the central cheque clearing system; as a result remittances cannot be sent. We need to bring these institutions to the clearing system. This is not an expensive process since with today’s technology anything is possible.
The next step on my agenda is asking the Government to channel all its social security payments through the banks.
How did it happen before?
It was physical. Take for example the Samurdhi scheme. The cost of running this scheme is Rs. 10 billion while another Rs. 10 billion is disbursed- which Half the scheme is to do with costs.
That can drastically be cut by using Samurdhi staff to do more productive work like developing those areas. And if the Samurdhi beneficiaries have bank accounts, we need to ask the banks to transfer the Samurdhi money to recipients. There are lots of other cascading benefits. For instance provide debt cards to the mothers in these families who will use this money responsibly. Thus the debt card becomes cashless transactable instrument that can be used in village shops and ‘kade’s’.
This system helps the Treasury become more efficient in targeting poverty unlike the present system of applying a broad-brush method to identify families that fall into this scheme.
Thus providing every citizen with a bank account is a must and the Government also benefits as tax collection becomes more efficient.
One of the fundamental duties of the CB is to advise the Government on economic policy and one of the crucial pieces of advice is that – not enough taxes are collected. Why? Because there are too many taxes – 25 in number. That needs to be reduced to five.
Take Georgia (in the former Russian states) for example. In Georgia, taxes account for 10 per cent of GDP compared to Sri Lanka where it is 12 per cent. In three years Georgia’s tax rate vis-à-vis GDP rose to 25 per cent. If we can do that we are out of the woods.
Our tax collection against GDP is 12 per cent and expenditure is 18 per cent. Even though people say the Government is bloated, it is not.
Looking at what has happened in terms of economic and monetary policy; is our policy direction right and/or has the external environment affected such policies?
What we have been following is the Chinese model. There has been a heavy Chinese focus since the end of the war and this model whether we like it or not, works. But it’s heavily dependent on investments. The Chinese are smart in channeling money into investments and ‘pouring concrete’. But they don’t work on winning the hearts and minds of the people.
Sri Lanka is a mirror image of what is happening in China where there was 10-20 years of ‘pouring concrete’ with GDP heavily skewed towards investment, not enough in consumption and today they are paying the price. Chinese banks are stretched; they are unable to lend any more money and the President has triggered a massive anti-corruption drive. Growth has fallen to 7 per cent from11 per cent. Sri Lanka has a similar kind of situation where investments are funded by Chinese loans and that needs to be sorted out. Thus casinos are being stopped and also the port city project.
The CB is recommending to the Government to simplify the tax system which will generate revenue and compensate for the slowdown in investments.
Through this process, consumption could be funded through the 100 day programme where commodities prices would be reduced. This way we have a better chance than China of stimulating the consumption side in the economy, since we have a large Sri Lankan expatriate workforce who will send more money home now that confidence has been restored. I’m optimistic that remittances will rise above the US$9 billion mark annually.
What are your comments on economic growth and allegations that data was doctored and didn’t
eflect the true situation?
From my initial findings here, the direction was broadly right. Even if growth was tweaked by 0.5 to 0.7 per cent higher than what it was, that doesn’t make a major difference either way.
Also remember, there is a major re-basing exercise at the Census and Statistics Department at the moment where items like haircuts, illicit alcohol sales, etc come into the calculation. This will be announced in June and when that happens there would be a big lift. The entire series is being changed and this process has been going on in the past few years. Inflation, based in 1954 samples, is also being re-based.
As far as I am concerned inflation is not a problem. Globally the problem is deflation. It has already begun in Japan while Europe is on the brink of deflation. Inflation in Germany is 1per cent which is virtually negative and even in the US, inflation had been below 1 per cent for a long time.
Globally what is happening is that the Chinese shocked the world economy in terms of becoming a manufacturing arm of the world because of cheap labour.
This has resulted in western workers being unable to raise their wages. In the US, studies show that 1 per cent of the population has control of over 50 per cent of the total income of the country. People owning assets like shares, etc can grow their income exponentially unlike wage earners because they are being replaced by Chinese, Vietnamese, etc.
This is a global phenomenon; happens everywhere even in Singapore. The net effect of that for a country like Sri Lanka is that inflation becomes purely a domestic issue revolving around the control of money supply and the budget deficit. If these are controlled, inflation can be controlled.
Thus in the budget it is paramount that the 100 day programmes incentives are funded by revenue. As long as this happens, inflation is manageable.
Has the CB in recent times gone beyond its brief in either policy formulation or other issues? Has there been
a politicisation of the CB?
All I can say is that in last year’s annual report there was a very clear praise of the Mattala airport, as one example, and such praise was perhaps a bit excessive. The Central Bank’s role is to be more objective… not gush about projects where the feasibility study had not been done.
From that point of view, the CB seems to have strayed from its role of being an objective advisor to the Government and the people of Sri Lanka.
But I wouldn’t say that the entire CB was corrupt and irredeemable. I don’t think the CB has lost its way – we just need a slight course correction to get back on track.
The issue is the balance of payments, particularly exports which hasn’t been properly looked at in the past 10 years. This has been one of the serious gaps in the policy framework. Many years ago, when free trade zones (FTZs) were built, they were filled up quickly. Today there are no new FTZs. Exports need a shot in the arm and this is the challenge for the next five years.
So how do we increase exports? There is a simple solution to this. Foreign investors need infrastructure and if we have zones, these will fill up. Ofcourse FTZs now are more complex than the old Katunayake and Biyagama zones. Now whole cities have to be built with its own power supply, housing, etc but it’s not difficult to raise money for such developments.
The Government is looking at a Western megapolis, which is the Prime Minister’s vision, from Negombo to Kalutara, as a region for about 10 million people. Just like an industrial trading hub. Unlike the port city, one needs to take a holistic view – railways, highways, etc. Japanese funding could be obtained for this.
For this kind of development, how many years are we looking at?
The Chinese can build a city for 10 million people in one year; I have seen it. This is why we need to keep our communication lines open with the Chinese. They have the expertise and the technology to do this. We are not burning our bridges with them. All that we are saying is that the port city is too small in the scheme of things. We need to think and look big and be the biggest megapolis in the Indian subcontinent.
The Indians will also join us. This is the kind of development we need rather than building casinos and a port city. That’s the vision of the current Government. And I think this will work.
How are the reserves holding?
There is a view that the rupee was
artificially kept high:
The CB has $8 billion in reserves which is equal to about five months of imports. The critical level for imports is under three months of imports. Thus we are way above that and comfortable for now.
The rupee is at a critical stage and the global market is very volatile. I have never before seen this kind of volatility in my entire career. Some currencies are yo-yoing around. We need to take a call whether we need to follow these trends.
I think Sri Lanka’s best strategy for the moment is keep the currency flexible but not to the point where it would endanger the entire financial stability of the country. Remember in addition to being an export economy, we also export labour. Remittances are a huge driver of the economy – $9 billion in a $65 billion economy which is huge.
Meddling with the exchange rate too much will affect the confidence of Sri Lankan expatriate workers who want to save some of the money to buy property. That is a factor which is independent of our export competitiveness.
On the export side, tea prices are likely to be affected by the Russian crisis where the rouble has collapsed, which means the demand for tea eases. However much we devalue the rupee, we won’t be able to recover the Russian market. Hopefully the Middle East markets will keep tea exports steady.
On garments, there could be an issue of competiveness but I would argue that the more successful niche like women’s lingerie for example is an inelastic and high value market and devaluing the rupee is not going to boost those exports.
Thus exchange rate flexibility has to be the last option; we have to preserve confidence. At the moment the markets are waiting for the budget and the parliamentary election in June, and in that situation you need an anchor and the currency plays that role.
On markets:
We should enter into a FTA with the US as the bulk of our markets are the US and Europe.
Is there a need for an IMF facility with the debt burden rising?
Right now there is no need for an IMF facility. But if the external situation, which is not too bad now, worsens after the June elections then we may need some kind of IMF support. The IMF is very supportive and a routine IMF mission is due here in end February.
When you took over, were you facing a daunting task of putting things right?
It’s not difficult. I started my career in the CB in 1983 (and left in 1994). Most of my batch-mates are here as deputy governors and they welcomed me very warmly. There’s nothing wrong in the bank; all we need is to make it more regulatory-oriented and less commercially involved.
| On his son-in-law connections with the CB and being a Singapore citizen When Arjuna Mahendran’s name emerged as the front-line candidate for the post of Central Bank Governor, a controversy erupted in the media and business circles whether he was the right person for the job. Questions of conflict of interest were raised as to some dealings by his son-in-law and being a Singapore citizen. His response: “On the issue of my son-in-law, to be honest I didn’t know he had a private dealer’s licence. When this controversy erupted in the media, he says there was a bidding process and he was the one who raised the most amount of capital to satisfy the CB requirements and therefore he got a licence. He has also resigned from the directorship of that company after I was appointed purely because he doesn’t want to have any conflict of interest. On the citizenship issue, the Bank of England has imported the Governor of the Bank of Canada to be its head. Thus I don’t see where nationality becomes an issue. The first Governor of our CB was an American (Sir John Exter). I explained to the President and the Cabinet that I am happy to give up my Singapore citizenship which was offered to me by the Singapore Government. I am happy to give it up and apply for dual citizenship, a process that has been delayed recently.” |