SECTOR ASSESSMENT (SUMMARY): FINANCE (SMALL AND MEDIUM-SIZED ENTERPRISES FINANCE AND LEASING) 1. Sector Performance, Problems, and Opportunities

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1 Small and Medium-Sized Enterprises Line of Credit Project (RRP SRI 49273) SECTOR ASSESSMENT (SUMMARY): FINANCE (SMALL AND MEDIUM-SIZED ENTERPRISES FINANCE AND LEASING) Sector Road Map 1. Sector Performance, Problems, and Opportunities 1. While small and medium-sized enterprises (SMEs) are often an important source of inclusive economic growth and job creation, Sri Lanka s SMEs have not made great progress in recent years. 1 Although they comprise nearly 90% of industrial establishments, they only contribute about one-fourth of the value added and a third of employment. 2. The ability of SMEs to access and manage finance is one of the factors that determines their ability to develop, grow, sustain, and stay resilient in a competitive economy. Despite many special SME loan schemes over the past several years, SMEs still struggle with accessing bank financing. The Institute of Policy Studies of Sri Lanka and the National Chamber of Commerce reported in a recent study that nearly half of SMEs consider access to finance as the most significant constraint in growing their business. 2 Other studies have reported similar results In accessing finance, SMEs are faced with the challenge of lack of collateral. Studies reveal that the difficulties that SMEs have in accessing credit in Sri Lanka are due to (i) shortcomings within SMEs, including poor knowledge of financial management, poor financial literacy, and lack of transparency in SME management; and (ii) shortcomings in the financial system because of a highly risk-averse banking system, lack of understanding of genuine SMEoriented banking practices, and insufficient mechanisms to improve information asymmetries in SME banking. 1. Finance Sector Overview 4. Sri Lanka has two key channels for SME financing: banks and financing companies. Overall, both are stable, improved their performance in 2014 over 2013, and provide a solid base for SME financing. In 2014, banks improved their business operations and risk management as reflected in on- and off-balance sheet operations, profit, risk indicators, liquidity, and capital. The banking system showed an overall increase in profit after tax of SLRs88 billion in 2014 compared with SLRs74.6 billion in 2013 (18.0% growth); assets grew by 17.3% year-on-year compared with growth of 16.5% in Asset quality improved during 2014 with the gross nonperforming loan ratio decreasing between 2013 and Liquidity ratios improved during 2014, and statutory liquid asset ratios of domestic banking units and offshore banking units were well above the statutory requirement. Finance companies and specialized leasing companies also showed improving performance because of recent improvements in business processes and financial recovery. 5. Regulatory policies introduced in 2014 strengthened risk management and public confidence in the finance sector. The standardized approach for operating risks under Basel II, the regulatory framework for valuation of immovable property, resulted in guidelines for 1 ADB Asia SME Finance Monitor Manila. In 2014, SME loans as a percentage of gross domestic product in Sri Lanka was unchanged and growth of the SME subsector was close to zero. 2 A. Wijesinha and N. Perera Banking on SME Growth: Concepts, Challenges and Policy Options to Improve Access to Finance in Sri Lanka. Colombo: Institute of Policy Studies of Sri Lanka. 3 International Finance Corporation Enterprise Surveys: Sri Lanka Country Profile. Washington; World Bank. Enterprise surveys.

2 2 information security management and increase of minimum capital requirements from They were the main regulatory policies introduced for banking. The finance sector consolidation program, implemented through mergers of banks and nonbank financial institutions regulated by the Central Bank of Sri Lanka, was a major regulatory policy implemented jointly by the central bank and the government as announced in the government budget for Accordingly, the plan envisaged reducing the number of nonbank financial institutions to around 20 from 58, with regulatory support and tax incentives. At the end of 2014, 10 mergers were complete and 22 were in process. Given several concerns raised in the process, the program was put on hold pending the findings of the consolidation review committee appointed by the new government. 6. Current interest rate conditions are benign and favor SMEs. The Central Bank of Sri Lanka decided to leave the benchmark interest rate at 6.0% in October 2015 following a previous rate cut in April Policymakers are confident that headline inflation would remain comfortably in the low single digits by the end of 2015, despite the impact of the depreciation of the Sri Lankan rupee against major currencies. In September 2015, headline inflation in the country fell 0.3% year-on-year from August 2015, following a 0.2% drop from July. The interest rate averaged 8.06% during , reaching an all-time high of 10.5% in February 2007, and a record low of 6% in April 2015 (Figure 1). 6.6% Figure 1: Sri Lanka Money Market Repurchase Rate % 6.4% 6.3% 6.2% 6.1% 6.0% 5.9% 5.8% 5.7% Source: Central Bank of Sri Lanka Annual Report Banking 7. The government has significant control over the banking system, with two state-owned banks accounting for 35% of total assets. At the end of 2014, the banking system comprised 34 licensed banks, with Cargills Bank commencing operations in April The total banking network included 25 licensed commercial banks, of which 12 were branches of foreign banks and 9 licensed specialized banks. 8. The banking system remained robust during 2014 and continued to expand its asset base maintaining its lead role in the finance sector. Asset growth gradually picked up during the last quarter of 2014, resulting in a marginal drop in excess liquidity in the system. Credit growth, which was moderate during the early part of the 2014 compared with the previous year, reported steady growth during the latter part of the year. Banking continued its focus on prudent

3 3 management of credit risk, market risk, equity risk, interest rate risk, exchange rate risk, and liquidity risk. Although the sharp fall in the price of gold in 2013 caused the impairment of many of the sector's gold-backed loans, the nonperforming loan ratio decreased during Licensed Finance Companies and Specialized Leasing Companies 9. While licensed finance companies (LFCs) and specialized leasing companies (SLCs) represent only 7% of Sri Lanka s financial system, they play a vital role. Their loan products correspond to the demands of many SMEs (Figure 2). LFCs and SLCs, along with microfinance institutions, often serve as the entry point into formal finance and provide SMEs with an opportunity to develop a credit history and financial acumen. LFC and SLC system asset growth moderated during However, the demand for credit picked up during the second half of Lower interest rates helped to improve credit demand and to maintain rising nonperforming loans at a manageable level. Mergers and acquisitions during the year helped to build up resilience and improve the soundness of the subsector. Further, in line with economic developments, several measures were adopted to strengthen risk management and build LFC and SLC capacity to facilitate better absorption of risks. Figure 2: Loan Portfolios of Finance Companies Finance leasing Hire purchase Secured loans and advances Pawning advances Loans against real estate Loans against deposits Others Billion SLRs. Source: Central Bank of Sri Lanka Annual Report Government s Sector Strategy 10. The Government of Sri Lanka has adopted policies and strategies to promote SMEs and microfinance, recognizing the advantage of these subsectors for development of the country, achieving balanced economic growth and equitable regional development, creating employment, and improving productivity. Moving beyond the task of traditional banking, commercial banks and development banks have moved forward to assure the proper functioning of SMEs through financial assistance along with advisory support and supervision, especially in marketing and introducing new technology to support them in continuing to modernize.

4 4 11. The government encouraged financial institutions to reach out to SMEs to enhance the financial facilities available for them, while functioning as advisory centers for SMEs. In 2014, state and private commercial and development banks provided approximately SLRs521,385 million to fulfill the funding needs of SMEs. 12. Globally, SMEs contribute more than 50% to gross domestic product in developed countries. In the European Union, SMEs constitute 99.8% of all firms, employing about 76 million people, representing around 67.4% of total employment in In the United States, SMEs constituted more than 50% of the nonfarm private gross domestic product and created 75% net new jobs in the economy. Thus SMEs have a significant role in generating employment, nurturing a culture of entrepreneurship, and supporting large-scale industries and opening new business. 13. As Sri Lanka begins a middle-income transition country, boosting the competitiveness of this wide segment of the private sector becomes a critical part of ensuring continued growth. Sri Lanka will find it increasingly difficult to compete against cheap labor in low-income economies, and with the technology and innovation-driven high productivity of more advanced economies. Some advanced economies have succeeded in this regard, in part, because of the strength of their SME subsector. In such economies, SMEs comprise more than 98% of total business establishments and contribute more than 65% of employment. 3. ADB Sector Experience and Assistance Program 14. The Asian Development Bank (ADB) and development partners have provided significant assistance with SME financing. The lessons from earlier engagements have fundamentally shaped this proposed ADB assistance and are described at length in a supplementary appendix. 4 4 Lessons from Previous Credit Lines for Small and Medium-Sized Enterprises (accessible from the list of linked documents in Appendix 2).

5 5 Problem Tree for Small and Medium-Sized Enterprise Financing Stifled economic growth and poverty reduction in Sri Lanka Effect Economic participation of SMEs is below potential business development services (marketing, accounting, technical support) access to finance Inadequate physical infrastructure (roads, energy supply) Core Problem Causes participation of SMEs in global value chain competition across FIs outside of mainstream areas of economy confidence of FIs in providing credit to new customers Higher cost of FI funds for long-term financing Underdeveloped capital markets Stifled growth of promising exportoriented clusters expertise of FIs on SME banking and risk management Insufficient credit guarantee scheme access of SMEs to collateral FI = financial institution (bank and nonbank financial institutions), SMEs = small and medium-sized enterprises. Source: