Snap devaluation - now or never?

Expecting the currency collapse to be shortlived, the Central Bank justified maintaining a steady 10% depreciation of the rupee over 1998, after having depreciated it by 7.4% in 1997.

The situation did not warrant panic. Export growth was respectable at 13.3% in US$ terms in 1997, the trade deficit fell for the third consecutive year and reserves were at 5.8 months of imports.

FDI was up 49% to US$129m and record privatisation proceeds pushed the BoP surplus upto US$ 162.9 in 1997 Jardine Fleming H.D.F. Stockbrokers report in their 'Spotlight on Asia' issue released recently, said. In the February 1998 report, Balancing Act JardineFleming said that the export sector, which accounts for the lion's share of exports— had not suffered a serious loss of competitiveness. The prospect of higher inflation, a rising Budget deficit and increasing interest rates argued a competitive devaluation. However, we did caution that FDI would suffer as the bulk of Sri Lanka's foreign investment is from East Asia, and problems could emerge in the medium term.

The bad news has worsened and the good news has turned bad, they say. The trigger was India's nuclear tests and the subsequent sanctions. The Indian rupee has lost almost 7% since the testing. Pakistan devalued its rupee by 4.2% in late June. Both India and Pakistan compete with Sri Lanka's exports of garments, rubber and leather products, and FDI, so the movement of these currencies is critical for Sri Lanka's exchange-rate management. Also, the weakening yen and the Japanese economy sliding into recession has raised worries of another round of devaluation, particularly if China reacts, JF HDF says.

The first sign of woe was the slowing export growth in December 1997. Garments continued to do well, but non-garment industrial exports fell 12.1% YoY over January-April 1998, while rubber exports fell 51% and coconut exports fell 29%. Fortunately, these items accounted for only about 30% of total exports, which helped keep overall export growth positive in l998. This changed in April, as garment exports (50% of exports) fell 3.5% YoY, causing export growth to decline for the first time in eight months. Tea exports performed well in 1997 and for the year to date; however, with prices coming off their peaks in recent weeks, tea could not be relied upon to bolster exports. The fall-out on the trade deficit has been contained, thanks to lower import prices due to depreciating currencies and falling commodity prices. Imports rose 2.4% and the trade deficit fell 4% YoY in January-April 1998. We forecast an export growth of 8.3% in 1998, from 13.3% in 1997.

Given the deteriorating export picture, worsening outlook for foreign investment and continued weakness of regional currencies, the pressure to devalue is rising.

In May, inflation was an annualised 9.2% a year end rate of 12% without devaluation, is forecast by JF HDF securities. Devalution makes sense in the current deflationary environment and falling import prices, as imported inflation would be minimised. Higher inflation is usually a concern as the Colombo CPI has an estimated 30% weighting for imported products (largely food). Devaluation also results in higher wages, fuel prices and transport rates. Hence, this is a good time for devaluation as oil prices are at historical lows and the currencies of Sri Lanka's two largest import partners—India (10% of imports) and Japan (8.5% of imports)—, have depreciated by almost twice that of the rupee they say. Hence, a devaluation of about 10% would increase inflation by about 2 percentage points over forecasts. This would relieve pressure on the trade deficit as lower import prices will cause the value of imports to remain flat, even if volumes rise. Given the current slack domestic demand for imports, import volumes should also fall the brokers say.

A subdued inflationary impact will allow interest rates to stay at current levels despite a devaluation. In addition, with loan demand remaining slack year-to-date, and the loan-to-deposit ratio at 77%, pressure on interest rates will remain low. The pinch will come on the Budget via higher rupee costs for US$-denominated defence imports, which is the government's largest expense (24% of spending). However, savings from reduced oil prices (which has not been passed on to consumers) and expected privatisation revenues of about Rs.10bn in 1998 will limit Treasury borrowing from the market. So the government has raised Rs 6.6bn from AirLanka and plantations. The balance will come from a 10% divestment of Sri Lanka Telecom. Flat interest rates in 1998 and a reduction in the Budget deficit to 7.3% of GDP in 1998 (1997: 7.9%) is expected . Finally a rupee devaluation will not substantially affect foreign-debt servicing as a depreciating yen will offset some effects of a weakening rupee. About half of total foreign debt is yen-denominated, and external debt servicing constitutes 3% of spending (domestic debt, 23% ), the brokers said.

In spite of the deteriorating export picture and thanks to slower import growth, trade deficit should rise by less than 8% in 1998. This may be revised down as import growth assumptions of 8.2% for 1998 look high. Hence, the current account deficit will remain under control at about 2.5% of GDP. Moreover, despite slower investment inflows and private-sector borrowing, the BOP should post a surplus of US$206.8m. At least US$100m will come from privatisation. External reserves will remain comfortable at around 5.5 months of imports, they said.

The concern then, is not so much this year but thereafter. As warned in the February report, once the dust settles in the region, East Asia will emerge lethally competitive in exports as well as in foreign investment.

With wages around the region falling in US$ terms, Sri Lanka is finding it difficult to project itself as a cheap labour source. Thus, attracting labour-intensive industries to soak up the nation's 800,000 unemployed will be an uphill task. FDI is also crucial to bridge the domestic savings investment gap of 8% of GDP. If the investment ratio were to rise, FDI would be even more critical.

Our GDP growth projections are 5.4% for 1998 and 5.6% for 1999. The risk of a downgrade in 1999 is high, they added.

Given the argument outlined, it would be prudent for the central bank to consider a snap devaluation now rather than later for immediate 10% devaluation and a further depreciation of about 3% over the rest of the year will bring the rupee to an end - 1998 rate of about Rs 75/US$. This would translate into an 18% YoY depreciation. The rupee is now at Rs. 65.23/US$, down 6.1% year-to-date. Since a devaluation is not predictable, forecast — for the moment remains - of a 10.3% YoY depreciation to Rs 68.25 by end 1998, and 5.4% YoY depreciation to Rs 72.15/US$ by end-1999.

UN wants to see Lanka competitive

United Nations Development Program (UNDP) in Sri Lanka has funded a comprehensive enterprise development program which is currently being implemented through the United Nations Industrial Development Organization (UNIDO), in co-operation with the Ministry of Industrial Development and the Ceylon National Chamber of Industries..

As a part of this project, The Centre for Enterprise Management Information Services (CEMIS), a special service designed to provide Sri Lankan businesses with modern information technologies, will be opened shortly, a news release says.

It will provide business with a greater competitive advantage through better management information systems and decision support tools.

The Centre has been established in the Department of Industrial Management, University of Kelaniya. CEMIS has been supplied with computer equipment, relevant software and resource personnel have been trained in Sweden. Singapore and Colombo.

Management buy outs and role of the venture capitalist

Management Buy Outs (MBO) are expected to motivate managers, make companies more efficient and remunerate the initial owners of the business.

Nice theory but does it actually work in practice?

How will salaried managers have the funds to purchase a company? Why would the present owners want to sell an existing business?

Who will finance the managers?

ln this article we attempt to provide answers to these questions.

MBOs are extremely popular in the US and Europe. Over thousand one hundred management buyouts were completed in Europe during 1997 ranging from small family businesses to subsidiaries of large listed businesses.

In the US the numbers are much larger and the MBO process is seen as an important contributor to the dynamism, efficiency and entrepreneurship of the economy.

MBOs are popular, liked and encouraged by all segments of the business community in the US and Europe because the transaction must be mutually beneficial for an MBO to take place.

In an MBO scenario only the owners of the business can press the start button to commence negotiations.

Unlike corporate take-overs an MBO is seen as a friendly take-over where the owners and managers negotiate to arrive at mutually agreeable and acceptable terms of transfer of ownership. This is why you never hear of hostile MBOs!

Selling the business to the management team could be the best option as the management team knows the business intimately and have a first hand knowledge of the true value and growth potential of the company.

Advantages to owners

Owners considering selling their business or part of the business will have the following advantages in an MBO scenario!

• Realisation of full value for a successful business;
• Ability to concentrate on core activities;
• Realise cash value of a family owned business when succession of ownership is not clear or next generation would like to use the proceeds to concentrate on other areas;
• Ability to retain part ownership of the business to share in future growth;
• Speed and confidentiality of sale while ensuring the continuity of the business;
• Retention of special relationships within the business.

In most instances selling a business in an MBO realises the maximum price and benefits to the vendor.

Benefits to Managers

An MBO provides great opportunities to managers as well as substantial risk and sacrifice.

Financiers will require that managers contribute a substantial part of their wealth to buyout the business.

Managers will also have to work much harder and believe in their ability to run the business successfully without the support of the parent company or previous owners.

In the vast majority of the cases this has proven to be little sacrifice compared to the potential benefits to managers.

Benefits to the management team include the following:

• Potential to gain substantial wealth through ownership and success of the business;
• Personal achievement;
• Control of the business.

The business and customers benefit by increased efficiency and dynamism of the management who are now motivated by the profits and success of their business. MBOs are also referred to by strategists as 'Motivation By Ownership' as management efficiency and productivity is seen to increase substantially after an MBO.

Factors for success

However success after an MBO is neither guaranteed nor easy. Success is commonly achieved by a combination of the following factors:

• Skilled, committed and motivated management team;
• A well established industry position for the business;
• A steady demand for the organization's goods and services;
• Ability of the company to function independently of parent and previous owners;
• The operational and financial structuring of the business;
• The backing of an experienced and committed financier.

The two most critical factors for success are the ability and motivation of the management team and the backing of an experienced and committed financier. The financier is most often a venture capitalist who is willing to invest risk capital, believes in the ability and integrity of the management team and the potential future success of the business.

The backing of a venture capitalist will add credibility to the managers proposals to purchase the company as the vendor will know that the necessary finance is available to the management team to consummate the transaction.

Financing the purchase price

Most MBOs are leveraged to give the managers the maximum possible equity stake after the buyout without significantly increasing risk or jeopardizing post MBO cash flow. In Sri Lanka however, an MBO cannot be levered directly through the company itself as company law prohibits a company giving financial assistance to purchase its own shares. This disadvantage can however be avoided when structuring the transaction to achieve the desired results.

ln a typically levered MBO the purchase price paid to the vendor and any additional financing infused into the company would be structured as follows:

Short term/intermediate term funding 5-20%

Long term senior or subordinated debt* 40-80%

Preference stock (coupon and/or convertible)* 10-20%

Common stock (equity)** 5-20%

* Venture capital company could take part of this

** Between the management and venture capital company

Venture capitalists will require that the management team invest a substantial portion of their wealth in the MBO for an equity stake in the business. Managers' investing their own money affirm their belief in the company and its future.

Managers must own a large enough stake in the company to benefit from its success and continue to be committed to the business. The venture capitalist will usually take a significant minority stake in the company.

The final structuring decision will be based on many factors but is primarily influenced by projected (with a good degree of certainty) cash flows of the company.

What is most interesting and encouraging is that managers have been able to become the eventual owners of the business by contributing just 5%to10% of the purchase price.

Value added by venture capitalist

Besides risk capital and financial expertise, venture capitalists will have management resources with previous MBO experience.

The management team will be faced with several tasks including negotiation, due diligence, tax implications, accounting and legal review, raising finance and loan capital.

The venture capitalist as an equity partner will assist in these matters.

Typically they will have invested in a number of companies and serve on their boards. This cross section of experience available to the venture capitalists will be a valuable contribution to the success of the business both during negotiating and structuring the transaction and management of the business.

The venture capitalist will usually invest with a view to realizing their investment within a period of 3 to 7 years when they will seek to sell their shares on the stock market after a listing, to a third party or to the other shareholders.

The return earned by the venture capitalist on its investment will depend on the success of the business and hence the venture capitalist will work together with the management team to ensure the profitability of the company.

We at Ayojana believe that the Sri Lankan business sector is sufficiently developed with a number of professionally run companies to be able to generate very interesting MBO opportunities.

Although we have seen and invested in Management Buy Outs in Sri Lanka we firmly believe that the quality, size and frequency of MBOs could and should increase benefiting present owners, management, financiers and the economy.

We believe what's been lacking in Sri Lanka is awareness among owners and management of MBO possibilities, advantages and financiers who actively seek out, encourage and have expertise in Management Buy Outs.

By Asanka Rodrigo & Andrew John, Ayojana Fund Management (Pvt) Ltd., Ayojana is a joint venture between the National Development Bank and Commonwealth Development Corporation (UK) and manages two venture capital funds, NDB Venture Investments and Ayojana Fund.

AIS takes over from TIPS

The first annual general meeting of the Association for International Standards (AIS) was held recently with Quintus Sooriyarachchi - Country Manager TIPS as chief guest.

Speaking at the AGM President Fayaz Saleem said that in their first year the association had identified and planned key areas of growth, whilst establishing the objectives of the association for its greater stability and longevity.

A fledgling association with a complement of 15 members marked the beginning of AIS on November 26, Mr. Saleem said in a news release.

The newly elected committee comprises F. Saleem - President, S. Moraes - Vice President, L. Jayakody - Secretary, L. Wellikala - Secretarial Asst. S. David - Treasurer.

Some of the activities of the association during its first year was the setting up of several committees, membership development, training and education, publicity and public relations, membership services, local and international liaison, social fund raising, and publications.

The Association now has 31 individual members, 11 corporate members and two associate members. AIS also held two educational presentations during the year which were successfully conducted.

According to Saleem, further programmes have been planned for the year including the ISO 9000 Consultants Training Programme, which was hitherto organised and implemented by TIPS (Technology Initiative for the Private Sector), but will now be conducted by AIS.

The programme will be carried out by Mr. Johnson, a renowned Expert and Trainer on ISO 9000 Quality Systems and Standards from the USA. An ISO 14000 programme is also being scheduled.

Other activities planned for the coming year are a National Awareness Campaign in October, a Lead Auditor Programme, in November the National Conference in July 99, and an ISO Road Show in Dec. 99.

Mr Saleem expressed his appreciation of the assistance and guidance given by Spencer King - CEO TIPs, Mr. Sooriyarachchi - Country Manager TIPS, and Sujeewa de Alwis, Director TIPS

Two extensions from Eagle

Eagle NDB Fund Management Co. Ltd. recently introduced two new product extensions branded as Eagle Nirathuru and Eagle Varika to their funds.

"These extensions provide tailor made solutions to investors with the use of Eagle Mutual Funds," Manjula De Silva, GM Eagle NDB, said in a company release.

Eagle Varika is a premium funding plan that enables an Eagle insurance policy holder to invest a lump sum in Eagle Mutual Funds to facilitate the periodic premium payments to a CTC Eagle life policy, utilizing both the capital invested as well as its earnings.

"This facility will eliminate paying insurance premiums periodically, while giving him the added advantage of making a single investment through the Eagle Varika plan that would be less than the total sum of the periodic premium payments he/she would otherwise have to pay to keep the life policy in force," the release says.

The minimum amount needed to be invested in Eagle Mutual Funds through the Eagle Varika plan would be Rs. 25,000/-, while the status of the investment made would be notified to the policy holder by Eagle NDB Fund Management Co. via an account statement that would be periodically sent.

Eagle Nirathuru is a periodic withdrawal plan whereby a single investment made in Eagle Mutual Funds enables the investor to periodically withdraw (monthly/quarterly/half yearly/yearly) a part of the capital he invested together with its earnings in equal instalments during a period of time opted for by him.

The withdrawal would be periodically effected by redeeming the required number of units from his/her investment in Eagle Mutual Funds. The amount would be directly credited to the investors' bank account, while the minimum amount needed to be invested in Eagle Mutual Funds through the Eagle Nirathuru plan is Rs. 25,000/-.

He also said that the investor would need to give his consent to Eagle NDB to redeem the required number of units regularly on his behalf to make the periodic withdrawals. This could be done by completing a 'Direction' form by the investor, along with the Eagle Mutual Funds application form, the release says.

In this instance too, the status of the investment made in Eagle Mutual Funds through the Eagle Nirathuru plan will be notified to the investor by means of an account statement sent periodically by Eagle NDB.

Eagle NDB is making every attempt to understand their customers' needs and offer solutions that would suit them best. "We want to encourage our clients to invest according to a customized personal financial plan," de Silva said.

Also present at the launch was Chandra Jayaratne, MD CTC Eagle Insurance, who received the first Eagle Varika investment from Eagle Sales Person D.P.W. Karunatilake on behalf of his client.

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