Economy navigates market turbulence

IMF sources last week said that Sri Lanka’s economic outlook and Budget 2014 are positive.

The economy continues to move forward, and has navigated recent market turbulence well.

Overall GDP growth has been solid, said permanent representative of the IMF in Sri Lanka, Koshi Mathai at a media briefing in Colombo.

He said that the consistency in policies, tax proposals, deficit reduction focus and the overall budget is positive.The media briefing was held after the conclusion of IMF Executive Board Ex-Post Assessment of Exceptional Access under the 2009 Stand-By Arrangement and First Post-Program Monitoring Discussion with Sri Lankan officials. According to the IMF assessment, Sri Lanka’s economy continues to move forward, and has navigated recent market turbulence well.

Overall GDP growth has been solid, but recent indicators underline some areas of concern. Trade activity has been slow to pick up, tax revenue and public spending (including capital expenditure) are relatively low, and private sector credit growth has been declining.

It projects real GDP growth of 6.5 percent for 2013, somewhat below the authorities’ forecast of 7 to 7.5 percent. Headline inflation fell to 6.2 percent in September 2013, from 9.2 percent at end-2012. Base effects have been an important factor, but pressures appears to be easing, consistent with more moderate economic growth and lower food prices.

The assessment projects end-2013 inflation at 7 percent. Risks to the inflation outlook stem mainly from potential upward shocks to world commodity prices and lagged effects of monetary easing.

The external position improved during 2013. Imports and exports slowed in the first half of 2013, reducing trade deficit. Exports have since started to pick up, while tourism receipts and inward remittances remain strong. This is expected to contribute to a projected 1½ percent of GDP reduction in the current account deficit in 2013, and broadly stabilise gross reserves.

Fiscal consolidation is facing headwinds. Despite some important tax reforms introduced in 2012, and the 2013 extension of the VAT to the retail and wholesale sectors, revenue performance has been weak thus far in 2013.

To some extent, low revenue reflects the weaker imports, but the numerous tax exemptions and tax administration weaknesses remain the important causes of lower-than-expected revenue.In response to the revenue shortfall, the authorities have kept spending under tight control and are committed not to exceed 5.8 percent of GDP 2013 deficit target. In Budget 2014, they are targeting a further deficit reduction, to 5.2 percent, based on continued restraint of current spending and steps to broaden the tax base.

During 2013, monetary policy has been progressively eased. In October 2013, citing benign inflation outlook and the desire to stimulate the economy to reach higher growth in 2014, the Central Bank of Sri Lanka (CBSL) cut policy rates by 50 basis points.

This followed the 50-point cut in May 2013 and a reduction of reserve requirements by two percentage points at end-June. The easing of monetary policy throughout the year has been slow to feed through to bank lending, and private credit growth has continued to slow.

As of June 1, 2013, the CBSL increased the reserve maintenance period of commercial banks from one week to two weeks, to allow greater flexibility in liquidity management, and further relaxation of foreign exchange regulations with effect from June 12, 2013.

The condition of the banking system has improved, and the Financial Sector Assessment Program update last year found that significant progress has been made in strengthening banking supervision.

Vulnerabilities still exist— expressed in the recent rise in nonperforming loans. The recent shift from concessional and bilateral loans to external borrowing by banks and private entities raises the risks to external sustainability.

The Executive Directors welcomed the opportunity to review macroeconomic and policy developments as part of post-program monitoring and the ex-post evaluation of exceptional access under the 2009 Stand-By Arrangement.

The directors were encouraged by Sri Lanka’s strong growth and moderating inflation, and by the economy’s resilience in the face of recent market turbulence. However, vulnerabilities remain, stemming from high debt and declining government revenues relative to GDP.

The directors commended the authorities’ commitment to fiscal consolidation. They welcomed ongoing expenditure restraint, but cautioned against further cuts in capital expenditure to meet fiscal targets.

They underlined the importance of putting tax revenues on an upward trajectory. They emphasised the need for further improvements in tax policy and administration, including elimination or rationalisation of exemptions and holidays.

The Directors said that the flexible exchange rate regime has acted as a buffer to external shocks, and welcomed the Central Bank’s move to a less active intervention strategy. In view of the risks of further market turbulence ahead, they emphasised the need to allow time for the effects of monetary policy to feed through to private credit and money growth before considering a further easing.

The Directors noted progress in financial sector development, and efforts to strengthen supervision and regulation.

Drop in gold prices hits pawning industry

The gold jewellery pawning sector in the country has been adversely affected following the drop in gold prices in the world market triggered by the shift in demand to other assets.

The price of a gold sovereign slumped from around US$ 1,800 to around US$ 1,200 last week causing problems for banks and financial institutes which grant loans on a percentage of the value of the precious metal. Certain banks and financial institutions will incur considerable losses due to the drop in gold prices. Rating agencies and economic analysts said that the recent drop in gold prices could turn out to be risky for Sri Lanka's banking industry as the non-performing loans (NPLs) in the pawning (or gold-backed) loans sector could increase.

The Finance Company PLC, Chairman Preethi Jayawardena said that the pawing business of the company has been affected badly due to the sudden drop in gold prices. He said that they will have to auction jewellery that has been pawned, at market prices.

Analysts said that many customers who had pawned their jewellery are not keen to redeem them as they could purchase gold at a lower price and convert them into jewellery.

TFC's exposure in the pawning sector is little over Rs.1 billion. We give around 80 percent of the value of the gold at pawning, Jayawardena said.

Experts in the sector said that it is the big players such as the State banks that will be affected badly rather than those with less exposure.

Gold merchants are said to gain in the long-term following the drop in gold prices.

The price of gold will stabilise to around Rs. 41,000 a sovereign and with the festive season around the corner the demand for gold will rise, a merchant said.

There will be a slight drop in prices of the precious metal due to the reduction in import duty, gold merchants said. They said that there will not be a major drop in prices as production cost is high.

Sources at Swarnamahal Jewellers said that the price of a gold sovereign will drop by around Rs. 5,000 following the reduction in import duty. The import duty on gold was slashed last week from 10 percent to 7.5 percent to spur sales. The price of a gold sovereign is Rs. 43,500.

Experts said that the expansion in gold backed loans by banks and financial institutions when gold prices shot up has exposed the banking sector to higher risk with the sudden slump in prices. A Standard and Poor's report said that it expects default in pawning loans to increase in the next 12 months unless clear signs of gold prices stabilising emerge. It said that nevertheless, banks’ overall earnings will offer sufficient cushion against higher credit costs in the pawning segment.

According to the report, pawning loans in Sri Lanka have grown with the steady rise in gold prices due to the zero risk weight on pawning loans in the calculation of regulatory capital ratios, and the absence of restrictions on loan-to-value ratios.

A spokesman for Edirisinghe Trust Investments Ltd (ETI) said that the company's pawning business has dropped to around 85 percent due to the drop in gold prices. He said that if the cost is not covered at auctions the company will repurchase the assets and convert them to 24 carat gold and sell them through Swarnamahal Jewellers as new jewellery to cover the advance and cost.ETI's pawning base is around Rs 6 billion. Last year is was Rs. 6.5 billion. The company has reduced the loan to value ratio from around 60 percent to 50 percent due to market fluctuations. “We give discounts up to 50 percent of the value or convert it into a term loan of six months to one year for jewellery that has sentimental value,” the spokesman said.

Pan Asia Bank, Deputy General Manager - Retail Banking and SME, Irishad Ally said that there will not be a major impact on earnings from pawning due to the drop in gold prices as the bank identified the issue early and took steps to minimise the impact. He said the bank's pawning base is around Rs. 6.8 billion.

He said that customers who have pawned jewellery which has sentimental value will redeem them than the assets that has no emotional value. “We expect the price of gold to stabilise and the industry to be back on track shortly,” he said.

Gold jewellery makers said that they will not be affected, as jewellery is made on orders.

Pattakannus, Chairman and Managing Director S.A. Thiagarajah said that the drop in gold prices will affect those who hold a large inventory. He said that the impact will be felt when banks sell the current stocks and import new stocks. The price of a gold sovereign rose to Rs. 60,000 in 2012. He said that the price of a gold sovereign rose from Rs. 300 to Rs. 700 overnight in 1971. The demand for gold fluctuates according to the strength of the dollar. When the dollar is strong the demand for gold declines.