BUSINESS MODEL

Operating Environment

The Macro Economic Analysis

The Global Economic Performance

The global economy grew at a moderate pace during 2013 at 3.0% exceeding the expectation of 2.9% as set out by IMF in October 2013. This growth however is marginally lower than the 3.1% recorded in 2012. This reiterates that the global economic growth continues to encounter several challenges across emerging and developing economies.

The emerging and developing economies largely benefited from increased demand from advanced economies. The same economies continued to be the major contributors of the global growth, continuing the shift in world economic powers towards them. However several risks remained, arising from the continued uncertainty regarding the US debt ceiling and the impact of the possible tapering of quantitative easing measures on emerging market economies.

Drivers of Global Growth

Advanced economies grew by 1.3%, a large share of this growth coming from the US with the easing of fiscal consolidation measures and a continuation of supportive monetary policy measures. The European Union also experienced further recovery as indicated by continued improvement in business indicators.

Emerging market economies slowed down during the year, growth being restricted to 4.7%, compared to 4.9% in 2012. India, Brazil and Central and Eastern Europe experienced sound growth over the year. China continued to hold its ground at 7.7% growth while the growth rate in Russia declined from 3.4% in 2012 to 1.5% in 2013. Among other countries that reported growth rates lower than 2012 who accounted for most of the decline in overall emerging markets segment were ASEAN countries, Mexico, Middle East and North African countries. Tightening credit conditions in response to the expected unwinding of quantitative easing measures adopted by advanced economies, capacity constraints and less room for policy to support growth were some of the reasons for the recorded slowdown in these emerging market economies.

Global Inflation Levels

Global inflation remained moderate and subdued with the easing of commodity prices and continued negative output gaps in advanced economies. However, inflation levels were exposed to the risks of the on-going instability in the Middle-East, with its potential impact on international oil prices. In advanced economies, inflation remained below target levels. In the European Union, slow growth and downward pressure on wages contributed towards maintaining inflation below targeted levels.

Future Expectations for Global Growth

Growth expectations are ambitious for the years ahead. The global economy is expected to grow by 3.7% in 2014. Advanced economies are expected to grow by 2.2%. United States is expected to grow by 2.8% fuelled by increased domestic demand and reduction in fiscal drag as a result of the recent budget agreement. Growth in the European Union is projected to strengthen to 1% in 2014 with much contribution anticipated from exports as opposed to domestic demand. On the emerging markets and developing economies, a 5.1% growth is anticipated for 2014.

World output: Past, present and future

Sri Lankan Economic Performance

Economic Growth

The economic growth was impacted by unfavorable weather conditions, subdued global growth and the lag effect of tight monetary policy measures introduced during the first half of 2012. However, the country managed to grow at a pace faster than most emerging economies at 7.2%.

Inflation

Inflationary pressure remained at benign single digit levels during the year, resulting from prudent demand management policies, stable international commodity prices and significant improvements in domestic food supplies. Year on year headline inflation declined to 4.7% in December 2013 from 9.8% in January 2013, while core inflation declined to a record low level of 2.1% in December 2013, on a year on year basis. Going forward, inflation is projected to remain at single digit levels during the remainder of 2014.

Balance of Payment

Exports recorded growth on a year on year basis, which were mostly supplemented by growth in tea and recovery of textile and garments. Overall import expenditure also dropped (during the first eight months of the year) as a result of policy measures adopted in 2012 to rationalize imports, lower demand for intermediate goods, mainly of petroleum and petroleum related products due to lower thermal power generation and revisions to customs duties together with reduced input demand from export industries and moderating international commodity prices. Reversing the deficit of USD 169 mn recorded during the first half of 2013, the overall BOP is estimated to generate a surplus of USD 990 mn for 2013, mainly benefiting from an improvement in the trade account, higher receipts from tourism and workers’ remittances, increased inflows to the corporate and banking sectors, including the receipt of proceeds from the bond issue of the National Savings Bank in September and inflows to the banking sector.

Exchange Rates

The exchange rate policy in 2013 focused on maintaining flexibility in the determination of the external value of the Sri Lanka Rupee. The Sri Lanka Rupee which was stable until mid-June 2013, depreciated through August 2013 responding to market conditions. With the receipt of higher foreign exchange inflows to the banking sector, the Rupee stabilized thereafter. Accordingly, the Sri Lanka Rupee depreciated against the US dollar only by 2.75% during the year to 31 December 2013, which is a minimal depreciation compared to few other Asian currencies.

Fiscal Management

Fiscal management was challenging during the first half of 2013, predominantly resulting from reducing government revenue. However, government expenditure was maintained within budgetary targets during the same period. As a result, the overall budget deficit during the first half of 2013 was 4.3% of projected GDP. The budget deficit for the year is estimated at of 5.8% for 2013.

Interest Rates

Easing monetary policy stance adopted by the Central Bank of Sri Lanka (CBSL) resulted in market interest rates being adjusted downwards during the year. Lowering of policy interest rates and the Statutory Reserve Ratio, increased levels of liquidity and improved foreign investor appetite, however together with lower credit disbursement by banks to the private sector exerted downward pressure on the yield rates of government securities and the same was witnessed in deposit rates within the banking sector to the public.

Banking Sector Performance

Asset Growth

The banking sector performed moderately well during the year, recording a growth of 16.6% in assets, the total assets nearing the LKR 6 tn mark. Credit growth saw moderation during the year mainly due to improvements in the fiscal consolidation, reforms in the state owned enterprises and the unexpected reduction in gold prices. The majority of the growth was generated by the Licensed Commercial Banks.

Main contributor towards the overall increase in the asset portfolio was the increase in investments, which recorded a 39% growth in 2013, compared to 15% in 2012.

Non Performing Loans (NPLs)

NPLs increased during the year across the industry owing to increased stress levels in loan recoveries, predominantly in the gold pledged loans category as a result of the decline in the price of gold across the world. The gross industry NPL ratio as at 31 December 2013 was 5.6% as compared to 3.7% for 2012.

Profitability

Profitability of the banking industry experienced a dip with a negative growth of 9.8% at Profit After Tax level, as compared with a positive growth of 26% for 2012.

Highlights of the Banking Sector - Growth Rates in Key Performance Indicators

* Source - Publications by Central Bank of Sri Lanka

National Vision and the Banking Sector

Sri Lanka aspires to be a South Asian economic hub, focused on five hubs - maritime, aviation, commerce and tourism, knowledge and energy. Underpinned by this vision, the Sri Lankan economy is targeted to grow at 6 to 7% annually and reach a per capita income of USD 4,000 by 2016.

Realization of this vision will, inter alia, require a paradigm change in the local banking sector. We see immense prospects for direct loans and syndications, project financing, SME development as well as roles in FDIs, mergers and acquisitions (M&A) and initial public offerings (IPO) in a growth focused economy. At the same time a few issues regarding the financial services sector and the banking sector in particular, need to be addressed.

Implications for the Banking Sector

The CBSL has announced a clear Road Map for the Banking and Finance sector, aimed at developing an industry comprising of an optimum number of players and healthy levels of competition among them. This Road Map envisioned for 2016, aims for the industry to have at least five Sri Lankan banks with LKR 1 tn or more assets, thereby such banks having a strong regional presence.

The Road Map has also brought to light the need for a large Development Bank that will provide substantial impetus to development banking activities in the country. We believe that the Bank has a very prominent role to play in the CBSL’s vision for the future of the banking and finance industry. The Bank is ready to embrace and welcomes positive changes that these new initiatives will herald.