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Sri Lanka’s Financial Services Sector Essay

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Updated: May 7th, 2022

Introduction

Sri Lanka is an emerging economy in South-East Asia with a population of 21, 283, 913 people (Means 2011). There are two ethnic groups including the Samhala and Tamil. Sri Lanka has dominated international headlines due to the civil war between the Tamil Tigers and the government in the north and eastern parts of the country. Results of the decades’ long civil war include increased civil strife and slow economic growth (Lakshman & Tisdell 2000, p.34). However, the country is on a recovery path since 2002 when the government and rebels reached a ceasefire. In mid-2009, the war ended with the Tamil Tigers declaring defeat. Sri Lanka’s economy has expanded significantly in the last decade. In the last five years, “the average Gross Domestic Product (GDP) growth is 6.5%” (Means 2011, p.2). In 2003-2007, the services sector accounted for 58% of the country’s GDP. Moreover, “10.3% of the services’ sector contribution in 2003 can be linked directly to the financial sector” (Means, 2011, p.2).

Successive Sri-Lankan governments have put increased emphasis on streamlining operations in the financial sector. One major catalyst towards increased government operations in the sector is to ensure increased access to credit. Access to credit especially among Small and Medium Enterprises (SME’s) is critical towards ensuring that the country realizes its economic goals. The global financial crisis 2007-2008 affected the country and thus linked to the slow economic growth in 2010 through to 2011. The following is a critical analysis of the country’s financial services sector. Among the aspects that will be tackled include the structure and operations of the country’s financial services sector. Similarly, an analysis into the effects of the global financial crisis 2007-2008 will be tacked. Finally, the paper looks into the opportunities and challenges of foreign financial services companies in Sri Lanka.

Structure of the financial system and operations in Sri-Lanka

Central Bank of Sri Lanka

The Central Bank of Sri Lanka (CBSL) oversees activities in the financial services sector in the country. Some of the major functions of the CBSL include supervision, liquidity management and instituting macro-economic policies (International Monetary Fund 2007). For example, during the global economic crisis, the CBSL instituted both fiscal and monetary measures to cushion the economy against the effects of the crisis. The major objective of the introduction of the measures was to stimulate the economy. Among the major reforms introduced include a government stimulus package (Central Bank of Sri Lanka 2009). This had a direct impact in government expenditure including increased spending on ongoing government projects. Additionally, in 2011, the CBSL ensured the rates remained steady. As a result, more banks were in a position to borrow from the bank. This has resulted in increased borrowing from commercial banks. Commercial banks, in turn, have increased lending to Small and Medium Enterprises (SME’S) thereby spurring growth in the economy.

Another role of the CBSL is supervision. The Central Bank oversees the activities of banks and insurance companies among other financial services providers in the country. This is in respect to the statutory and regulatory policies relating to the financial services sector. For example, the recent credit growth in the banking sector can be attributed to increased risks in the sector. This resulted in the review of Sri Lanka’s Macro-Prudential Index (MPI) from 1(low) to 3 (high). Macro-Prudential Index acts as an indicator of potential stress in a country’s banking system (FitchRatings 2012). Therefore, the CBSL is expected to liaise with all relevant stakeholders in order to address the increased risk levels as outlined. Some of the stakeholders that the CBSL intends to liaise with include commercial banks’ boards. CBSL is expected to instruct boards to play an integral role in the assessment of banks’ risk management programs.

Similarly, the CBSL liaises with major players in the insurance industry to ensure continuous growth in the insurance sector. One of the major stakeholders in the insurance sector is the Insurance Board of Sri Lanka. Reforms in the insurance sector include “the liberalisation and deregulation of the insurance sector which has seen increased competition in the sector” (The Economic Intelligence Unit 2006, p.160). Therefore, as the level of competition increases, risks associated with the industry are also on the increase. As a result, the CBSL is expected to ensure increased monitoring of the insurance sector to ensure that customers are not exposed to unnecessary risks.

The Central Bank of Sri Lanka is also charged with the responsibility of liquidity management. Tools used in liquidity management include reserve requirements. Other tools include open market operations and standing facilities. The above tools enable the Central Bank to conduct its supervisory role effectively in view of increased volatility in the financial services sector after the global financial crisis. Banking Sector Structure

Commercial banks in Sri Lanka are divided into two major categories including Local Specialized Banks (LSBs) and Local Commercial Banks (LCB’s). The main difference between these categories of banks is that LSBs are not mandated to deal in foreign currency or accept demand deposits. Examples of Local Specialised Banks include development banks and specialised savings banks. There is a total of 31 licensed banks in Sri Lanka. These include 22 Local Commercial Banks (LCBs) and nine Local Specialised Banks (LSBs) (FitchRatings 2012).

In Sri Lanka “there are two state-owned commercial banks namely Bank of Ceylon (BOC) and the People’s Bank (PB)” (FitchRatings 2012, p.3). The banks have assumed a dominant position in the country’s banking sector. The position is bolstered by several things including their wide presence across the country. Similarly, the government and various state-owned co-operations borrow from these particular banks.

As regards customer deposits “Bank of Ceylon (BOC) and the People’s Bank (PB) accounted for 50% of the total bank deposits in 2004” (The Economic Intelligence Unit 2006, p.155). Also, the banks accounted for 50% of the total assets in the banking sector. Similarly, “Bank of Ceylon and People’s Bank accounted for 41% of the total loans in the country’s banking system in 2012” (FitchRatings 2012, p.3). This is heavily influenced by borrowing amongst state-owned corporations. Similarly, the specialised banking subsector is dominated by two banks namely the National Development Bank (NDB) and Development Finance Corporation of Ceylon.

Banks offer their services through established branches and outlets (FitchRatings 2012). Many banks in Sri Lanka are yet to embrace such technologies as internet banking. Also, most banks are well established in the western part of the country. Therefore, the north and eastern part of the country lags behind in the provision of banking services. The civil war (1983-2009) largely contributed to the dilapidated infrastructure in these parts of the country. Consequently, many banks are not in a position to offer their services in these particular parts of the country.

The Insurance Board of Sri Lanka oversees activities in the country’s insurance industry. There are 21 insurance companies registered with the board. The insurance industry posted positive results in 2011 with a growth of 18.5% (FitchRatings 2012). Insurance companies offer a broad range of services that target both individuals and businesses. However, the suspension of Ceylinco Takaful in 2009 has had a negative effect on the industry. In 2002 for example, Ceylinco Insurance’s market share was 27.2% (The Economic Intelligence Unit 2006). The company’s market share was second to government-owned Sri Lanka Insurance Corporation.

Effect of the Global Financial Crisis (2007-2008) on the financial sector in Sri

Lanka

The Global financial crisis in 2007 through to 2008 had several effects on the Sri Lankan economy. These effects include;

Reduced Exports’ Earnings

The manufacturing sector in Sri Lanka is heavily dependent on imported machinery. Therefore, increased prices for imported machinery as a result of the crisis-affected many firms’ profitability. Similarly, the manufacturing sector employs 26% of the total workforce in Sri Lanka (South Asian Microfinance Network, 2007).

Sri Lanka’s major trade partners include the United States and European Union. The above markets account for up to 60% of Sri Lanka’s total exports and 90% of the country’s textile exports (South Asian Finance Network 2007). Therefore, the effect of the crisis in these particular markets trickled down to the Sri Lankan market. For example, the demand for textiles dropped by 7% in 2008, therefore, putting a dent in the country’s export earnings.

Huge Fiscal deficit

The Sri Lankan economy is heavily reliant on economic aid as a tool towards meeting the country’s budgetary deficits. The situation is further compounded by the country’s huge debt. Therefore, the country has remained highly reliant on international financiers including the International Monetary Fund (IMF) and World Bank. However, these institutions were forced to reduce financial aid to countries including Sri Lanka due to increased constraints (International Monetary Fund 2007).

Decreased financial aid has a direct impact on the economy and also on the country’s developmental budget. Increased constraints, therefore, imply that government resources can only cater to the country’s recurrent expenditure (Edirisuriya 2007). This affects major development projects being undertaken by the government affecting their completion time.

Decreased remittances from Sri Lankans working Abroad

Remittances from Sri Lankans living abroad are the second highest foreign exchange earner after textile and garments. Increased remittances from Sri Lankans working abroad affect the country’s balance of payments. Similarly, the above remittances stimulate domestic consumption (South Asian Microfinance Network 2007). This is mainly because money sent from countries including the United States is used in the local economy. Therefore, households receiving payments are in a position to alter their budget and thus increase their consumption. Increased consumption translates into increased demand thus firms are expected to increase productivity. This improves the firm’s bottom lines.

Sri Lankans living in countries whose economy was hard hit by the crisis have reduced their remittances to their country. Some factors that have contributed to the above situation include an increased rate of unemployment. Therefore, Sri Lankans who have had no formal education were subject to the massive job cuts experienced in these economies. Also, many companies engaged in a major restructuring that affected most employees’ terms of employment.

Reduced foreign direct investment

Foreign direct investment refers to a situation where a company based in one country starts operations in another country. This is done either by acquiring an existing company or building a plant or factory in the second country. In 2005, foreign direct investment accounted for 1.2% of Sri Lanka’s GDP (South Asian Microfinance Network, 2007). In 2009, however, the figure reduced with foreign direct investment accounting for 0.8% of the country’s GDP.

Foreign direct investment in Sri Lanka in 2010 was constrained to entrepreneurs from the Far East where countries were least affected by the crisis Therefore, major investors especially in the revamped tourism sector in the country from the United States and European Union shied away (South Asian Microfinance Network, 2007). This has had a direct impact on the country’s economy.

Reduced Economic growth

Sri Lanka has enjoyed steady economic growth from 2005 averaging 6.5% per annum. However, the global financial crisis altered this pattern where economic growth in 2008 was 3.5% (South Asian Microfinance Network, 2007). Therefore, decreased economic growth has had a direct impact on the country’s macro-economic goals. Sri Lanka is on a recovery path after decades of civil strife. The country’s government struggles with the provision of basic amenities including health and education institutions in some parts of the country. It is vital that the country maintains growth momentum so as to remain competitive with neighbours who enjoy robust economies. Diversification of exports is an area on which the government has placed increased emphasis towards. This ensures that the country’s over-reliance on agricultural based is decreased with a shift towards increased production of capital goods.

Opportunities and Challenges of foreign financial services companies in Sri Lanka

Some of the opportunities available to foreign financial services companies include an improved business environment. Sri Lanka ranks lowly in regard to the provision of business permits and a viable business environment to potential investors (FitchRatings 2012). The government is expected to review bureaucratic procedures in the process of issuing business permits. Investors in the financial services sector, therefore, are in a position to introduce their products in the market in a reduced time duration.

Similarly, such government efforts including improved infrastructure in critical fields such as telecommunications help cut operation costs. Operational costs in the banking sector for example reduced by 0.2% in 2010 (FitchRatings 2012). Human resource cost is the main cost driver but with continued engagement with employee’s union, the costs will be stabilized increasing the financial services providers’ margins.

The civil war in Sri Lanka is attributed to volatility in the country’s equity market. However, after the end of the war in 2009, investors have increased confidence in the market. Therefore, foreign firms can take advantage of the above situation. This is because they are in a position to convince both local and foreign investors Financial services providers will be in a position to expand quickly thus taking advantage of the huge unbanked population in the country.

In 2011, the economic growth rebounded where 8.1% growth was recorded. Continuous economic growth in the country is characterised by the rapid expansion of the country’s agricultural sector. Therefore, there is increased demand for credit and thus foreign services providers could take advantage of the projected expansion. Similarly, the revamped tourism sector contributes to increased demand for other products including insurance products (Dabour 2003, p. 90). Hotel and tour firms are required to provide insurance for their employees and visitors alike.

Some of the challenges facing the financial services sector in Sri Lanka include government interference. For example, in 2007, the government introduced legislation where insurance companies to work with the National Insurance Trust Fund. The insurance companies are required to take up to 50% of their reinsurance business with the institution. This affects the companies’ operations and independence which affects their profitability (International Monetary Fund 2007).

Additionally, corruption is rife in the Sri Lankan business environment. This affects new and existing enterprises where companies do not operate on a level playing field. The government is expected to put measures aimed at addressing the vice. This includes encouraging business practices such as open tendering and also strict guidelines into requirements for foreign companies joining the country.

Also, the Central Bank of Sri Lanka should enjoy increased autonomy and also ensure that membership of the Monetary board does not, compromise the bank status. For example, the presence of a controller of state banks compromises the board’s supervisory role (International Monetary Fund 2007). This is especially in regard to state-owned banks. This is a deterrent to foreign companies especially in the banking sector where they would also agitate for representation on such matters.

Conclusion

Sri Lanka’s economic recovery is spurred by other factors including high literacy rates in the country. Therefore, quality human capital is available for existing and potential enterprises in the economy. The country’s financial sector is the mainstay of the country’s economy. Therefore, increased numbers of reforms are required to positively transform the sector. This acts as a catalyst for economic growth in the next decade. However, in order to realize the projected growth, increased commitment from all stakeholders especially from the government is required.

References

Central Bank Sri Lanka 2009, Annual Report 2009. Web.

Dabour, N 2003,’Problems and Prospects of Sustainable Tourism Development in the OIC Countries: Ecotourism’, Journal of Economic Cooperation among Islamic Countries, Vol.24, pp. 25-62

Edirisuriya, P 2007,’Effects of Financial Sector Reforms in Sri Lanka: Evidence from the Banking Sector’, Asia Pacific Journal of Finance and Banking Research, Vol. 1 No 1, pp. 45-64

FitchRatings 2012, The Sri Lankan Banking Sector, Special Report. Web.

International Monetary Fund 2007, Web.

Lakshman, W D & Tisdell CA 2000, Sri Lanka’s Development since Independence: Socio-Economic Perspectives and Analysis, Nova Science Publishers, Huntington, New York Means, R 2011, Sri Lanka, Our World, Colombo.

South Asian Microfinance Network (SAMN) 2007, Economic and Financial Overview Sri Lanka. Web.

The Economic Intelligence Unit 2006, Industry forecast December 2005; Sri Lanka. Web.

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