Report and Recommendation of the President to the Board of Directors Sri Lanka Project Number: 41932 October 2007 Proposed Loans Democratic Socialist Republic of Sri Lanka: People’s Leasing Company Limited and Commercial Leasing Company Limited In accordance with ADB’s public communications policy (PCP, 2005), this abbreviated version of the RRP excludes confidential information and ADB’s assessment of project or transaction risk as well as other information referred to in paragraph 126 of the PCP. CURRENCY EQUIVALENTS (as of 18 September 2007) Currency Unit – Sri Lanka rupee/s (SLRe/SLRs) SLRe1.00 = $0.008807 $1.00 = SLRs113.55 ABBREVIATIONS ADB – Asian Development Bank AFD – Agence Française de Développement CBSL – Central Bank of Sri Lanka CLC – Commercial Leasing Company Limited DFCC – Development Finance Corporation of Ceylon DMC – developing member country GDP – gross domestic product IRR – internal rate of return LCB – licensed commercial bank LIBOR – London interbank offered rate LOLC – Lanka Orix Leasing Company Limited LSB – licensed specialized bank NDB – National Development Bank NPL – nonperforming loan PLC – People’s Leasing Company Limited ROA – return on assets ROE – return on equity SLC – specialized leasing company SME – small- and medium-sized enterprise SOE – state-owned enterprise TA – technical assistance VAT – value-added tax NOTES (i) The fiscal year (FY) of People’s Leasing Company Limited ends on 31 March. (ii) The fiscal year of Commercial Leasing Company Limited ends on 31 December. (iii) In this report, “$” refers to US dollars. Vice President L. Jin, Operations 1 Directors General R. Bestani, Private Sector Operations Department (PSOD) K. Senga, South Asia Department (SARD) Directors A. Sharma, Governance, Finance, and Trade, SARD W. Willms, Capital Markets and Financial Sectors, PSOD Team leaders P. Bracey, Investment Specialist, PSOD P. Marro, Senior Investment Specialist, SARD Team members W. Greene, Investment Specialist, PSOD A. Mohammed, Senior Counsel, Office of the General Counsel J. Romero-Torres, Financial Specialist, SARD CONTENTS Page INVESTMENT PROPOSAL SUMMARY i I. THE PROPOSAL 1 II. BACKGROUND AND RATIONALE 1 A. Economy 1 B. Small- and Medium-Sized Enterprise Sector 1 C. Problems Affecting the SME Sector 2 D. The Financial Sector in Sri Lanka 3 E. The Leasing Sector in Asia 4 F. The Leasing Industry in Sri Lanka 4 G. ADB’s Sector and Country Strategy and Assistance to the Leasing Sector 5 H. ADB’s Private Sector Development Strategy 6 I. ADB’s Financial Sector and SME Strategy for Sri Lanka 6 III. THE BORROWERS 8 A. People’s Leasing Company Limited 8 B. Commercial Leasing Company Limited 9 IV. PROPOSED ADB ASSISTANCE 9 A. Project Selection 9 B. Proposed Loans 10 C. Pricing 10 V. PROJECT BENEFITS, IMPACTS, ASSUMPTIONS AND RISKS 10 A. Justification for ADB Participation 10 B. Environment and Social Safeguards 12 C. Anticorruption Policy: Combating Money Laundering and the Financing of Terrorism 12 D. Records, Auditing, and Reporting 12 VI. EXPOSURE LIMITS 12 VII. ASSURANCES 13 VIII. RECOMMENDATION 13 APPENDIXES 1. National Strategy for Small- and Medium-Sized Enterprise 14 Sector Development in Sri Lanka 2. Details and Structure of the Sri Lankan Financial Sector 15 3. The Leasing Sector in Sri Lanka 20 4. Development Impact Framework 24 5. Environmental Management System Guidelines 26 6. Summary Poverty Reduction and Social Strategy 27 i INVESTMENT PROPOSAL SUMMARY The Borrowers People’s Leasing Company Limited (PLC) and Commercial Leasing Company Limited (CLC)—both headquartered in Colombo, Sri Lanka. Proposed Asian Direct loans of (i) up to $10 million to PLC, and (ii) up to $7.5 million Development Bank to CLC. (ADB) Assistance Classification Targeting classification: General intervention Sector: Finance Subsector: Finance sector development Themes: Private sector development; sustainable economic growth Subthemes: Private sector investment; promoting economic efficiency and enabling markets Project Description The proposed ADB assistance is expected to strengthen the leasing industry, and expand the funding resources and financial services available to the small- and medium-sized enterprise (SME) sector in Sri Lanka. The activity of leasing companies in Sri Lanka is constrained by the need to borrow at short maturity to fund a business that lends at a longer maturity. The underdeveloped nature of the corporate debt market in Sri Lanka has made nonbank leasing firms heavily dependent on commercial banks for their funding through short-term borrowings and commercial paper. This has resulted in maturity mismatches in asset and liabilities and higher cost of funds for these institutions. The proposed loans from ADB to the two companies will give them access to long-term funds—enabling them to promote alternative and more competitive financing instruments to SME entrepreneurs to promote their operations and profitability and enhance their competitiveness. Use of Proceeds The proposed loans will be used to provide leasing facilities to SMEs, especially to support business in rural areas in Sri Lanka. Sponsors and (i) PLC was established in August 1995 as a fully owned Shareholding subsidiary of People’s Bank, the second largest state-owned Structure bank in Sri Lanka. PLC is incorporated as a private limited liability company. It has been the market leader in the leasing sector in Sri Lanka for the past 5 years. (ii) CLC, Sri Lanka’s third largest specialized leasing company, was established in 1988. Initially, the principal shareholders were Commercial Bank of Ceylon Limited and Singer (Sri Lanka). In May 1989, Chemanex Limited was admitted as the third principal shareholder. The company was converted to a ii public company in June 1992 and is listed on the Colombo Stock Exchange. Justification The companies’ focus on SMEs will improve funding availability to sections of the Sri Lankan economy left underserved by commercial banks. From a development perspective, a well-functioning leasing industry is an important financing tool for SMEs. The lack of assets that can be used as collateral for bank loans particularly constrains SMEs. When credit is available from informal sources, it tends to be short- term and too costly for investment financing. Leasing and supplier credit are often the only source of credit available to SMEs. By offering leasing companies debt with maturity similar to the duration of leases, ADB will (i) improve the competitiveness of the leasing sector, and (ii) promote the development of SMEs in accordance with ADB’s country strategy for Sri Lanka. By strengthening the leasing sector, this project can also boost capital markets development. Once leasing companies have established an operating history, they can tap equity and debt markets. As a follow-up to an earlier loan provided by ADB to another leasing company in Sri Lanka (Lanka Orix Leasing Company Limited [LOLC]), ADB is in discussions with LOLC to assist it in the securitization of part of its lease portfolio. It is expected that about 400 SMEs will be assisted through lease financing, which would result in additional capital formation, value added, employment and foreign exchange earnings/savings, and promotion of new entrepreneurs. This is fully in line with the focus of the Government of Sri Lanka, which has given priority to the development of enterprises by new entrepreneurs and of the SME sector in general. Loan Terms The proposed loans will be in US dollars. The maximum tenor of both loans will not exceed 5 years. The interest rate will be the market rate for this type of borrower and instrument. The proposed loans will have the benefit of security over certain assets of the borrowers. Environmental and Both companies have been classified category FI with respect to Social Safeguards ADB’s Environment Policy (2002), and category C with respect to ADB’s Involuntary Resettlement Policy (1995) and Policy on Indigenous Peoples (1998). No involuntary resettlement or any impact on indigenous peoples is expected from the activities financed by ADB’s loans. I. THE PROPOSAL 1. I submit for your approval the following report and recommendation on the proposed loans of (i) up to $10 million to People’s Leasing Company Limited (PLC), and (ii) up to $7.5 million to Commercial Leasing Company Limited (CLC). II. BACKGROUND AND RATIONALE A. Economy 2. Sri Lanka is a trade-oriented economy, partly because of its lack of natural resources. Wholesale and retail trade (trade in exports, imports, and domestic goods and services) is the largest single subsector, accounting for 21.6% of gross domestic product (GDP) in 2005. The combined services sector—which includes transport, communications, financial services, and tourism—generates more than 55% of GDP. Telecommunications, the most dynamic subsector, has consistently recorded a double-digit annual growth rates since 1998. 3. Manufacturing accounts for 60% of total industrial output. The sector also includes mining, electricity, water, and construction. Privately owned export-oriented factories produce over 95% of manufacturing output. The manufacturing base is dominated by the garment industry, although the production of food and beverages, as well as chemical and rubber-based goods, is also considerable. Although its significance has declined in the recent years, the agricultural sector remains important, directly accounting for around 17% of national output and employing over one third of the workforce. 4. Although privatization has reduced the role of the public sector in manufacturing, the state continues to dominate the financial sector and utilities, and has a quasi-monopoly in healthcare and education. It is also the largest property owner (90% of all land). The role of the Government of Sri Lanka (the Government) in the employment market is also substantial. Over 1 million people are employed in the civil service and semigovernmental bodies, meaning that Sri Lanka has one of the highest ratios of public employees to population in Asia. Expenditure on civil servants and the huge political establishment accounts for around one third of the Government’s recurrent expenditure, equivalent to almost 6% of GDP in 2005. 5. In late December 2004, a major tsunami claimed about 31,000 lives, left more than 6,300 missing and 443,000 displaced, and destroyed an estimated $1.5 billion worth of property. Growth, partly spurred by reconstruction, reached 5% in 2005 and more than 7% in 2006, the highest recorded growth since 1978. The GDP growth rate was 6.4% for the second quarter of 2007. 6. About 800,000 Sri Lankans work abroad (90% in the Middle East) and send more than $1 billion a year home—the third highest foreign exchange earner for the country. B. Small- and Medium-Sized Enterprise Sector 7. Small- and medium-sized enterprises (SMEs) account for a large share of establishments and employment in Sri Lanka: 80–90% of the total number of enterprises and 75% of employment (including the agriculture sector). At the sector level, SMEs account for 65% of total tea production, 50% of apparel and garment manufacturing, more than 70% of the public bus transportation sector, 80% of domestic trade activities, 45% of tourism and recreation services, and 50% of the local construction industry. Within the manufacturing sector, SMEs 2 account for about 96% of industrial units, 36% of industrial employment, and 20% of value added. Enterprises employing 5–29 workers are predominant in terms of the numbers of establishments among SMEs. The typical unregistered firm employs family labor, supplemented by 2–3 hired workers. However, the industrial value-added figure is only 20% of the national total. 8. Despite their potential importance, the performance of SMEs is not easy to measure in Sri Lanka, as definitions of SMEs have varied considerably over time and between institutions. Conventionally, employment numbers are used to classify SMEs. In Sri Lanka, enterprises are divided into (i) small-scale enterprises with 5–49 employees, (ii) medium-scale enterprises with 50–149 employees, and (iii) large-scale enterprises with more than 150 employees. On this basis, and in terms of the International Standard Industrial Classification of industries, SMEs are found in all subsectors of the economy, with a concentration in the manufacturing sector. 9. However, the definition adopted by various banks suggests the need for a more liberal enterprise fixed asset value, excluding land and buildings, of SLRs100 million (about $1 million) to capture the full extent of SMEs in Sri Lanka. C. Problems Affecting the SME Sector 10. More than 80% of the SMEs in Sri Lanka have difficulty accessing financial services and securing financing. This is mainly due to (i) a strong risk-adverse bias of banks with respect to SME lending; (ii) the absence of a diversified financial sector capable of serving SMEs, partly caused by weaknesses in the judicial system as it applies to registering and enforcing security interests;1 (iii) concentration of SME lending in Colombo, Gampaha, and Kalutara; and (iv) limited availability of medium to long-term credit. 11. SME loan sizes are small. Relative to larger firms that borrow in larger amounts, banks incur higher administrative and processing costs on their SME portfolios. The available information, track record, and reputation of a potential SME borrower is also likely to be limited, as is the financial accounting system—adding further to the costs of loan processing and increasing the uncertainty and, consequently, the credit risk. The probability of failure is high, even for well-conceived new ventures. Therefore, banks offer lending rates that are significantly higher than for large enterprises. The higher lending rates limit SMEs’ access to credit from the formal financial sector. 12. To address the various constraints experienced by the SME sector and to create the enabling environment, the Government commissioned a task force in 2001 to study and recommend actions to stimulate the SME sector (Appendix 1 contains an overview of the key recommendations). This resulted in the presentation of a white paper in 20022 and the establishment of an SME Authority by an act of parliament in March 2006. 13. The Government’s development agenda, outlined in its discussion paper “Mahinda Chintana”,3 provides a 10-year development framework (2006–2016). It embodies combining market-based economic policies, including foreign direct investments, with support for domestic enterprises. To achieve high growth rates, emphasis is on investments in infrastructure and the knowledge economy, with focus on regional development. A greater role for the private sector 1 ADB. 2005. Sri Lanka Financial Sector Assessment. Manila. 2 Available: http://www.ips.lk/publications/series/gov_reports/sme_white_paper/sme_white_paper.pdf 3 Available: http://www.treasury.gov.lk/EPPRM/npd/pdfdocs/budget2007/MahindaChintana TenYearDevelopmentPlan.pdf 3 underlines the development agenda. To address regional inequalities, the Government has taken forward its commitment for facilitating regional public infrastructure development. Resources have also been earmarked in the budget for promoting value addition in SME produce through research and development. Import duty has also been removed on machinery and equipment for sectors such as tea, rubber, and coconut coir. D. The Financial Sector in Sri Lanka 14. The past two decades witnessed significant financial reforms in Sri Lanka. Reforms These comprised interest rate deregulation, restructuring of state-owned banks, allowing entry of private sector financial institutions, easing restrictions on foreign financial institutions, reducing directed lending, and a shift in the focus of banking sector supervision from micro- intervention towards prudential regulations. As of 30 June 2006, the Sri Lankan financial sector consisted of (i) 23 licensed commercial banks (11 domestic private banks and 12 foreign banks); (ii) 14 licensed specialized banks (6 regional development banks, 1 national savings bank, 2 state-sponsored long-term lending institutions, 2 housing finance institutions, and 3 private savings and development banks); (iii) 28 registered finance companies; (iv) 13 insurance companies; and (v) 2 public pension funds. 15. The banking sector is the dominant subsector, accounting for about 57.5% of the total assets of Sri Lanka’s financial system. Even though a large number of licensed banks exist in the country, the stability of the financial system is primarily dependent on the performance and financial strength of the six largest licensed commercial banks, consisting of the two state- owned banks and the four large domestic private commercial banks. 16. The two state-owned banks, People’s Bank and Bank of Ceylon, play an important role in the domestic banking sector—holding over 40% of commercial banking assets. Although the market shares of People’s Bank and Bank of Ceylon have significantly dropped in the last 5 years, while the share of private banks’ total assets grew from 34.5% in 1998 to 43% by the end of 2005,4 the state banks have nationwide branch networks and have mandates to meet the policy objectives of providing financial services throughout the country and targeting government priority sectors rather than pursuing purely commercial objectives. However, they remain highly inefficient and undercapitalized. 17. Nonetheless, with continued reforms being undertaken, the nonperforming loan (NPL) ratios of the state-owned banks declined from 18% in 2003 to 8% in June 2006, and reached similar levels to those of domestic banks. Capital adequacy ratios have also improved to 8% of the total assets, and steps have been taken to further enhance the regulatory and supervisory framework—including plans to adopt the Basel II capital accord by 2008. 18. Commercial interests and competition for deposit and loan customers have led a number of the commercial banks to lend more aggressively to SMEs. Banks such as Sampath, Hatton National Bank, and Commercial Bank of Ceylon are playing a lead role in this regard. Although encouraging, these resource mobilization activities will primarily fund activities that carry less relative risks for banks, such as housing and car loans, and then be available for lending to SMEs. Their volume is also limited, given the relatively high short-term interest rates. Additionally, high unit transaction costs in processing relatively small SME loans remains a problem. Appendix 2 contains details and the structure of the financial sector in Sri Lanka. 4 International Monetary Fund. 4 April 2006. Financial Sector Quarterly Update. Washington: IMF. 4 E. The Leasing Sector in Asia 19. In most developing countries, capital markets are relatively undeveloped and banks are often unable or unwilling to undertake term lending. Banks prefer to lend to larger, established businesses with well-developed balance sheets and credit histories. Operations in microenterprises and small businesses are cash flow oriented but rarely have organized historical financial records or the assets needed for collateral for conventional bank financing.5 As such, in developing countries in general but in Asia in particular, there is an often unmet need for lease financing from SMEs. 20. The leasing industry in Asia makes an important contribution to the region’s economic development by providing a financing tool to both large enterprises and SMEs. In doing so, it increases the level of private investment in capital equipment. The proposition that underlies the concept of leasing is that an enterprise earns profit from the use of assets rather than ownership of assets. In developing countries with unclear property rights, poorly functioning asset registries, and weak laws of secured transaction, leasing can provide an attractive alternative to both lessees without collateral and lessors wishing to improve the possibility of repossession if necessary. 21. By supporting policy reforms and contributing private sector investment, ADB has played a critical role in launching the leasing industries in a number of Asian countries such as Bangladesh, India, Indonesia, Pakistan, and Philippines. However, the leasing industries in most of ADB’s developing member countries (DMCs) remain underdeveloped. A recent study commissioned by ADB6 on the leasing industry in 13 DMCs indicated that the total annual leasing volume in these countries is less than $7 billion compared to a global industry of over $500 billion, and accounts for an average penetration of 0.4% of GDP7 versus more than 1.0% in developed countries. F. The Leasing Industry in Sri Lanka 22. Sri Lanka recorded a leasing penetration of approximately 2.7% of GDP in 2006, according to the Leasing Association of Sri Lanka. This is significantly larger than that of any other DMC in the region, mainly because the leasing sector in Sri Lanka developed much earlier than in other DMCs in the region, and local banks were very reluctant to extend credit to SMEs—enabling leasing companies to fill the gap. 23. Sri Lanka’s leasing industry is driven by 72 entities, which include 20 specialized leasing companies (SLCs), 28 finance companies, 15 commercial banks, and 9 licensed banks.8 The annual total disbursements of finance leases of all registered leasing firms increased to SLRs78.8 billion ($0.70 billion) as of 31 March 2007 from SLRs64 billion ($0.62 billion) in 2006.9 Of the 20 SLCs, 7 companies accounted for 83% of the total assets.10 The total assets of these SLCs increased by 25% to SLRs67 billion from the year earlier, while total finance leases increased by 11% to SLRs29 billion. 5 World Bank. 2002. Leasing to Small Businesses and Micro Enterprises, Policy Research Working Paper Washington. 6 ADB. 2005. PSOD Leasing Industry Report. Manila. 7 Bangladesh (0.33%), China, People’s Republic of (0.16%), India (0.21%), Indonesia (0.69%), Kazakhstan (0.38%), Malaysia (0.36%), Pakistan (0.53%), Philippines (0.13%), Sri Lanka (2.27%), Uzbekistan (0.38%). 8 People’s Leasing Company Limited: http://www.plc.lk/investor/corporate_information.shtml 9 Leasing Association of Sri Lanka, 2007. 10 Central Bank of Sri Lanka. 2006. Annual Report 2006, Colombo: Central Bank of Sri Lanka. 5 24. The pinnacle years in the Sri Lankan leasing industry were 2005 and 2006, recording 20% growth in the inception of new businesses. Leasing companies reported increases in profitability from a low of 25% to 200% in 2006. Most of the new market entrants were bank subsidiaries rather than specialist leasing companies, creating fear among existing companies that the newcomers were largely aggressive, opportunistic, and ready to dominate the market— but unlikely to stay if there was a market downturn. The market became divided between formal leasing companies and informal companies that use leasing and hire purchase11 to disguise their intent to diversify their ability to lend. 25. A high concentration of the leasing portfolio of SLCs is in vehicle financing (81%). However, the risks associated with possible defaults are largely mitigated by the nature of finance leases, where the vehicle is considered the security and SLCs have absolute ownership of such vehicles. The Central Bank of Sri Lanka (CBSL) does not consider this concentration a major risk to the industry, as vehicles financed are used for purposes such as public transport, goods transport, and personal use by clients. However, CBSL is encouraging SLCs to diversify their leasing portfolios by providing facilities for the purchase of capital equipment such as machinery. 26. The NPL volumes reported by the seven largest SLCs have shown a decreasing trend recently.12 The NPL ratio of SLCs reached 2.9% (30 June 2006). The share of NPLs relating to leases continued to decline and reached 6.1% as of 30 June 2006. Appendix 3 contains further information on the leasing sector in Sri Lanka. G. ADB’s Sector and Country Strategy and Assistance to the Leasing Sector 1. Sector Strategy 27. ADB has been actively promoting the leasing industry in Asia. It has provided a number of technical assistance (TA) projects to support the emergence of leasing, which has proved its effectiveness—particularly in countries where the banking sector was not able to offer loans with adequate tenor to secure the acquisition of capital goods. 28. In June 2005, ADB commissioned an internal research paper on the leasing industry in its DMCs. The paper identified the following opportunities for ADB interventions: (i) the non- automobile equipment segment remains underfunded, (ii) sustainable local currency medium- term funding is insufficient, (iii) increased focus is needed on SMEs and rural enterprises, and (iv) successful development of leasing sectors should be replicated in new geographical areas. ADB developed this initiative to increase SMEs’ access to finance, and support rapid growth of the leasing sector in Sri Lanka. 2. Country Strategy 29. ADB’s country and strategy program 2004–2008 for Sri Lanka13 acknowledges the importance of private sector development as a key way of accelerating GDP growth, creating jobs, and raising efficiency and productivity in all sectors. 11 Hire purchase is a means of obtaining the use of an asset before payment is completed. A hire purchase contract involves an initial or down payment, followed by a series of hire charges at the end of which ownership passes to the user. 12 Central Bank of Sri Lanka. 2006. Financial System Stability Review 2006, Colombo: Central Bank of Sri Lanka. 13 ADB. 2003. Country Strategy and Program (2004–2008): Sri Lanka. Manila. 6 30. In particular, the country and strategy program states ADB’s support to the Government’s strategy to stimulate the private sector in general and SMEs in particular. In this respect, ADB’s strategy is two-pronged: (i) Promote an enabling environment for private sector development using ADB’s public sector window. (ii) Directly invest in private sector companies using loans and equity. 31. The country strategy and program update 2006–200814 also emphasized the need for ADB to promote SME development and microfinance. 32. The proposed loans would also align with ADB’s current poverty reduction strategy,15 which states that ADB seeks to promote “sound and efficient banking systems and capital markets,” since these are seen as “indispensable for macroeconomic stability, mobilizing savings, and ensuring availability of long-term financing, an essential requirement for pro-poor growth.” H. ADB’s Private Sector Development Strategy 33. ADB’s private sector development strategy16 specifically refers to ADB’s role in strengthening DMC capital markets, including the leasing sector, and notes the critical importance of well-functioning financial systems for the private sector. Many DMCs need to strengthen their financial institutions and create diversified financial markets that can finance private sector-led growth. ADB has supported financial sector reform programs through public sector operations and/or direct investments in financial intermediaries in several DMCs (footnote 8). 34. The strategy notes that ADB will complement funding with capacity building and governance strengthening for financial institutions. It will support policy reform to enhance regulation and supervision, develop sound financial systems, and deepen and broaden securities markets (footnote 8). The proposed loans are consistent with this strategy. I. ADB’s Financial Sector and SME Strategy for Sri Lanka 35. ADB’s approach to facilitating financial sector development in the short to medium term is to (i) promote good governance over the financial markets by improving the understanding of key governance principles and best practices, building capacity for good governance, and institutionalization of good governance principles through organizational restructuring; (ii) mobilize financial resources from commercial sources, and when necessary, with the support of ADB’s guarantee facility, for relending to private sector companies through domestic financial institutions; and (iii) develop a network of specialized financial institutions (e.g., cooperatives, nongovernment organizations, and credit funds) and mainstream suitable credit facilities among existing financial intermediaries to target the weaker economic sectors (including microenterprises, small- and medium-scale industries, retail low cost housing, and rural areas). 14 ADB. 2005. Country Strategy and Program Update (2006-2008): Sri Lanka. Manila. 15 ADB. 1999. Fighting Poverty in Asia and the Pacific: The Poverty Reduction Strategy. Manila. 16 ADB. 2000. Private Sector Development Strategy. Manila. 7 36. ADB has provided sustained support for SME sector—through broader financial markets and fiscal improvement programs as well as SME-focused interventions.17 Long-term structural issues, such as development of the capital market and availability of alternative financial sources of medium to long-term funds to the private sector, are being addressed through the above mentioned ADB SME projects. Continuing ADB support in this area has included development of contractual savings institutions, alternative sources of medium to long- term funds, the insurance industry and pension and provident funds, and liberalization of investments of these institutions to include private securities in the capital market. 37. The following initiatives are expected to deepen and improve the efficiency of the financial markets as well as enhance corporate governance: (i) developing securitized debt and equities markets under ADB’s Financial Sector Development Program (1990);18 (ii) strengthening of the Securities and Exchange Commission; and (iii) the introduction of a securitization bill and amendment of the Securities and Exchange Commission Act (1991) under the ongoing Financial Markets Program for Private Sector Development Program.19 The ongoing Fiscal Management Reform Program20 is also helping to create an enabling environment to foster mobilization of tax revenues, improve the effectiveness of public expenditures, accelerate fiscal decentralization, and improve coordination to place public finances on a sustainable path. These structural measures are long-term initiatives whose impact will only gradually take hold after consistent implementation. ADB is also providing extensive support for infrastructure development that will enhance the competitiveness of SMEs and provide the basis for a higher GDP growth rate. 38. In addition to policies introduced by the SME policy unit at the National Enterprise Development Authority, the ADB-financed SME Sector Development Program21 established polices to reduce the cost of operating and financing SMEs—including reduction of corporate income tax for SMEs, abolition of turnover tax on banking and financing activities, harmonization of tax incentives, and the abolition of stamp duty on letters of credit. Commercial legal reforms, 17 ADB. 2004. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the Financial Markets Program for Private Sector Development, R265-04. Manila (Loan 2138, for $60 million, approved on 15 December 2004); ADB. 2004. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the Fiscal Management Reform Program, R261-04, Manila (Loan 2130, for $45 million, approved 14 December 2004); ADB. 2000. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the Private Sector Development Program, R269-00. Manila (Loan 1800/01, for $85 million, approved on 12 December 2000); 1994. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the Fourth Development Finance Loan, R85-94. Manila (Loan 1302, for $75 million, approved on 28 June 1994); 1990. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the Financial Sector Program, R174-90. Manila (Loan 1051, for $80 million, approved on 20 November 1990); 1987. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the SME Industries Project, R158-90. Manila (Loan 0873, for $15 million, approved on 8 December 1987); and 1985. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the Development Financing Project, R118- 85. Manila (Loan 0754, for $20 million, approved on 26 November 1985). 18 ADB. 1990. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the Financial Sector Development, R174-90. Manila (Loan 1051, for $80 million, approved on 20 November 1990). 19 ADB. 2004. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the Financial Markets Program for Private Sector Development Program, R265-04. Manila (Loan 2138, for $60 million, approved on 15 December 2004). 20 ADB. 2004. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the Fiscal Management Reform Program, R261-04. Manila (Loan 2130, for $45 million, approved on 14 December 2004). 21 ADB. 2001. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the Small and Medium Enterprise Sector Development Program, R254-01. Manila (Loan 1896, for $60 million, approved on 20 December 2001). 8 such as the Bankruptcy Act (2002), are under way to provide for court-supervised restructuring of SMEs in the event of financial default. An integrated approach for enhancing SMEs’ access to finance and business development services has also been initiated. III. THE BORROWERS A. People’s Leasing Company Limited 39. PLC is a specialized leasing company, incorporated on 22 August 1995, with headquarters in Colombo. It commenced operations on 31 May 1996 and is a fully owned subsidiary of People’s Bank, which is the second largest bank in the country and owned by the Government. PLC was initially established to carry out finance leasing for customers of People’s Bank. To date, it has a network of 18 branches across Sri Lanka and has access to the branch network of People’s Bank, which is the largest in the country. 40. In 1996, PLC became a participative credit institution for a concessionary line of credit backed by the Government of India and given to the Government of Sri Lanka, through People’s Bank. By using this line of credit, long-term credit is extended to purchase capital goods of Indian origin. Having access to this funding mechanism has been instrumental for PLC to become a dominant player in financing public transport vehicles. Unlike other leasing companies, PLC has targeted the passenger bus transportation sector in Sri Lanka, which has been plagued by underinvestment for several years. 41. PLC was one of the first SLCs to be selected as a participating finance institution for the ADB-funded Tea Development Project,22 which started in 1999 and was completed in December 2005. The project was designed to assist the Government in (i) increasing the income of tea smallholders within a sustainable system, and (ii) improvement of the environment. The project focused on institutional reforms to increase the efficiency and effectiveness of tea-related institutions, and to direct more funds for replanting. It provided credit financing channeled through participating financial institutions for (i) replanting, (ii) rehabilitation and modernization of tea factories, (iii) commercial production of high quality planting materials, and (iv) facilities for collection and transportation of green leaf. The project also strengthened tea smallholder development societies and producer associations, improved workers’ housing and sanitary facilities, provided rural feeder roads, and produced afforestation. 42. More recently, PLC became a participating finance institution for ADB’s Plantation Development Project,23 which aims to develop the plantation sector of Sri Lanka. Under this credit scheme, regional plantation companies and their subsidiaries and sub-lessees are eligible to borrow loans. The project commenced in 2003 and will end in 2009. 43. In November 2005, PLC established the Islamic Finance Services Unit—functioning under Shariah Law—with the objective of venturing into the untapped market for Islamic finance in Sri Lanka. This is the first such unit to be set up by any leasing company in Sri Lanka. The key difference between Islamic and conventional finance is the role of interest. Interest is 22 ADB. 1998. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the Tea Development Project, R171-98. Manila (Loan 1639, for $35 million, approved on 10 November 1998). 23 ADB. 2002. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Sri Lanka for the Plantation Development, R156-02. Manila (Loan 1914, for $10 million, approved on 13 September 2002). 9 prohibited by Islamic finance. Since its establishment less than 2 years ago, the unit has seen dramatic growth with a current receivables portfolio of SLRs558 million. 44. PLC is also a participating finance institution in the “e-Friends 2” fund, sponsored by the Japan Bank for International Cooperation, which aims to provide low-cost funding and TA to firms engaged in waste management, resource recovery, and pollution control. 45. Finally, PLC is one of the participating finance institutions of a credit line sponsored by the French Development Agency (AFD) under the Construction Sector Development Project to assist construction and public work related to post-tsunami reconstruction. The credit facility agreement was recently signed between the Government and AFD to borrow €10 million. The project has the following components: (i) Construction Sector Development Project (€9 million), and (ii) the creation of an advanced construction training academy (€1 million). B. Commercial Leasing Company Limited 46. CLC, Sri Lanka’s third largest specialized leasing company, was established in 1988. Initially, the principal shareholders were Commercial Bank of Ceylon Limited and Singer (Sri Lanka). In May 1989, Chemanex Limited was admitted as the third principal shareholder. The company was converted to a public company in June 1992 and CLC is listed on Colombo Stock Exchange. The current shareholder structure is shown in Table 3. Table 3: Current Shareholder Structure Shareholders Current Ownership (%) Chemanex Limited 36.7 Singer Sri Lanka Limited 30.0 Commercial Bank of Ceylon Limited 30.0 Minority shareholders 3.3 Total 100.0 Source: Commercial Leasing Company Limited IV. PROPOSED ADB ASSISTANCE A. Project Selection 47. An ADB fact finding mission visited Sri Lanka in May 2007 to discuss the features of ADB’s nonsovereign operations with government authorities and state-owned enterprises (SOEs). Facilitated by the Strategic Enterprise Management Authority, the mission made a presentation on ADB’s nonsovereign operations to about 20 SOEs, including People’s Bank and PLC. Meetings were also held between ADB and PLC as a follow-up to the presentation. 48. The loan to CLC was discussed in detail with the company during an ADB mission to Sri Lanka in June 2007. The mission met with CLC, which conveyed interest in obtaining financial assistance from ADB. ADB’s initial contact with CLC was arranged by the Maldives Finance Leasing Company, which had received financing from ADB via the South Asian SME Leasing Facility approved in March 2007 (footnote 14). 10 B. Proposed Loans 49. ADB assistance to both leasing companies will be in the form of secured loans in US dollars. The tenor of both loans will be 5 years and principal repayments will be amortizing. The proceeds of the loans to both companies will specifically fund SME clients of their leasing business. The loans will be secured by a charge on a portfolio of already existing lease receivables of each individual company 50. Since both loans from ADB will be denominated in US dollars, ADB has discussed in detail how the companies intend to hedge themselves against possible currency risks. Both companies will retain the funds borrowed from ADB and place them in a foreign currency deposit with a local bank without converting them to local currency and then borrow Sri Lanka rupees against this deposit. They have followed the same funding strategy with all their other outstanding foreign currency loan commitments. 51. The proposed loans will be sourced from ADB’s ordinary capital resources and will carry an interest rate based on the London interbank offered rate plus a margin determined by ADB’s Pricing and Credit Enhancement Committee. The committee will also determine the amount of upfront and commitment fees. C. Pricing 52. Pricing will be determined by the Credit Enhancement and Pricing Committee of ADB. V. PROJECT BENEFITS, IMPACTS, ASSUMPTIONS AND RISKS A. Justification for ADB Participation 1. Primary Objective a. Strengthen the Leasing Industry 53. The proposed ADB assistance is expected to strengthen the leasing industry, and expand the funding resources and financial services available to the SME sector in Sri Lanka. The activity of leasing companies in Sri Lanka is constrained by the need to borrow at short maturity to fund a business that lends at a longer maturity. The underdeveloped nature of corporate debt market has made nonbank leasing firms heavily dependent on commercial banks for their funding through short-term borrowings and commercial paper. This has resulted in maturity mismatches in asset and liabilities, and higher cost of funds for these institutions. b. Promote SME Growth 54. The proposed loans from ADB to the two companies will provide them access to long- term funds, and enable them to promote alternative financing instruments to SME entrepreneurs to promote their operations and profitability and enhance their competitiveness. 55. The Project is in line with ADB’s country strategy for Sri Lanka. It will promote private sector participation in SME development. The demonstration effects related to long-term funding will be positive. 11 56. The Project also complements ADB’s public sector approach, as exemplified by ADB’s recent financial markets loan (footnote 21). This program is intended to facilitate participation of the private sector, including SMEs, in the Sri Lankan economy by supporting government reforms to eliminate impediments to and develop opportunities for their involvement. c. Improve Broader Capital Markets Development 57. Leasing companies can also boost capital markets development. Once they have established an operating history, they can tap and foster equity markets. Their demand for term debt broadens the term lending options for banks, finance houses, pension funds, and insurance companies. They can also issue bonds or other marketable instruments. Finally, leasing companies can securitize their lease receivables, taking some assets off the balance sheet to achieve higher leverage and better returns and adding another tradable instrument to local capital markets. ADB is currently in discussions with LOLC, which received an earlier loan from ADB,24 regarding possible securitization of part of their lease portfolio whereby ADB would provide a guarantee to guarantee the issue and/or purchase the mezzanine tranche of such a structured transaction. This would represent one of the first true sale securitization deals in the capital markets of Sri Lanka. d. Rationale for Adopting Subsovereign Modality in the Case of PLC 58. The proposed nonsovereign loan to a government-owned entity such as PLC is consistent with ADB’s policy to provide financial assistance to public sector enterprises without government guarantees, provided that they satisfy the criteria of autonomy and managerial freedom in operating the enterprise concerned. As outlined in ADB’s Innovation and Efficiency Initiative,25 numerous SOEs are creditworthy and have the long-term financial viability to borrow without government guarantees. They constitute a “third generation” of potential ADB clients, increasingly important as borrowers separate from the sovereign. These entities play an important role in creating employment and providing basic public services. Giving them access to affordable long-term credit is critical to promoting economic growth. PLC has been the market leader in the leasing industry in Sri Lanka for the past 5 years and has been competing with more than 70 private sector owned entities. It has experienced management, which has consistently shown strong financial performance, and has built up sizeable experience and exposure in SME financing. It clearly fits the requirements of ADB’s Innovation and Efficiency Initiative to provide nonsovereign financing to SOEs with a strong balance sheet, track record, and private sector focus. 2. Development Impact 59. Assuming an average lease size of $50,000, it is expected that about 400 SMEs will be assisted through lease financing, which would result in additional capital formation, value added, employment, and foreign exchange earnings/savings and promotion of new entrepreneurs. This is fully in line with the focus of the Government, which has given priority to the development of enterprises by new entrepreneurs and of the SME sector in general. 60. Moreover, a robust leasing industry has the potential to contribute to the development of capital markets by introducing SMEs to formal financial markets and providing demand from leasing companies for capital markets funding. 24 ADB. 2007. Private Sector Investment Facility for Lanka Orix Leasing Company (LOLC), IN7251/2321. Manila. 25 ADB. 2007. Progress Report on the Innovation and Efficiency Initiative September 2005—December 2006. Manila. 12 3. Measures for Development Impact 61. ADB has prepared a development impact framework (Appendix 10) to measure the expected development impact of its intervention. The development impact will be measured in three distinct categories: (i) private sector development, (ii) business performance, and (iii) economic sustainability. B. Environment and Social Safeguards 62. Environment. This financing is classified category FI. All borrowers will be required to adopt appropriate environmental management systems in accordance with the guidelines in Appendix 11. 63. Social Safeguards. This financing is classified category C. No involuntary resettlement or any impact on indigenous peoples is expected as a result of this financing. All sub-borrowers are extremely small and serve individuals and SMEs. Their clients are in the private sector and do not have the power to trigger involuntary resettlement. A summary poverty reduction and social strategy is in Appendix 12. C. Anticorruption Policy: Combating Money Laundering and the Financing of Terrorism 64. The borrowers have been advised of ADB’s Anticorruption Policy (1998, as amended to date) and policies relating to the combating of money laundering and the financing of terrorism. Consistent with its commitment to good governance, accountability, and transparency, ADB will require PLC and CLC to institute, maintain, and comply with internal procedures and controls following international best practice standards for the purpose of preventing corruption or money laundering activities or the financing of terrorism and covenant with ADB to refrain from engaging in such activities. The documentation between ADB and each company will further allow ADB to investigate any violation or potential violation of these undertakings. D. Records, Auditing, and Reporting 65. The borrowers will (i) maintain accounting, management information, and financial control systems acceptable to ADB; (ii) maintain independent auditors from auditing firms licensed to operate in Sri Lanka and acceptable to ADB and will authorize such auditors to submit financial statements to ADB at least annually; and (iii) permit ADB representatives access to all sites where its activities are conducted as well as to its books, accounts, and records, and will permit ADB (if and when it deems necessary) to engage auditors at their own expense to audit the accounts and accounting systems of each company. The deadline for the submission of audited accounts will be 120 days from the end of each year; and narrative and unaudited financial information, including a balance sheet and income statement of the companies, must be submitted within 40 days from the end of the relevant quarter. VI. EXPOSURE LIMITS 66. If approved, these loans will be ADB’s seventh and eighth nonsovereign investment in Sri Lanka. They will represent 1% of ADB’s total nonsovereign portfolio and will increase ADB’s expected exposure to the nonbank financial institutions and specialized banks from 6.1% to 6.4%, and its aggregate expected exposure to Sri Lanka from 1.1% to 1.6%. The proposed loans are within approved exposure limits. 13 VII. ASSURANCES 67. Consistent with the provisions of the Charter, ADB will obtain confirmation from the Government that it has no objection to ADB financing prior to any funding being made available. 68. ADB will enter into suitable loan and security documentation and other required legal documents, following approval of the proposed financing by ADB’s Board of Directors. These agreements will be on terms and conditions satisfactory to ADB. VIII. RECOMMENDATION 69. I am satisfied that the proposed loans would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve loans of (i) up to $10,000,000 to People’s Leasing Company Limited (PLC), and (ii) up to $7,500,000 to Commercial Leasing Company Limited (CLC), from ADB’s ordinary capital resources, on such terms and conditions as are substantially in accordance with those set forth in this report, or as may be subsequently reported to the Board. Liqun Jin 31 October 2007 Vice President 14 Appendix 1 NATIONAL STRATEGY FOR SMALL- AND MEDIUM-SIZED ENTERPRISE SECTOR DEVELOPMENT IN SRI LANKA Key Recommendations (i) The Government should adopt the vision for the small- and medium-sized enterprise (SME) sector as set out in the white paper to provide policy direction for the future overall strategy and plans for implementation. (ii) Use the definition recommended by the task force as a standard for data collection, policy analysis, and implementation of SME sector development programs. (iii) Establish a high-powered SME policy unit at the Ministry of Enterprise Development, Industrial Policy, and Investment Promotion. (iv) Establish an SME authority, a full-fledged autonomous institution for SME development. (v) Facilitate ongoing restructuring activities of the Investment Development Board with necessary funding and administrative support. (vi) Improve and consolidate financial assistance available for SMEs. (vii) Implement low-cost credit negotiation and project monitoring activities initiated by the Investment Development Board. (viii) Encourage the active participation of venture capital companies and leasing companies to provide credit support for SMEs. (ix) Disburse loan and allied facilities with the assistance of business development services (BDS) providers. (x) Amend the Loan Recoveries Act (1990) and provide opportunities for distressed companies to be restructured. (xi) Install financial discipline in SMEs. (xii) Establish technical service centers at district level. (xiii) Establish a technology development fund. (xiv) Introduce a voucher scheme for SMEs to engage in research and development work. (xv) Create an SME website. (xvi) Initiate low-cost advertising and sales promotion programs for SMEs. (xvii) Commission an annual survey and a magazine on SMEs. (xviii) Maintain a comprehensive and up-to-date BDS database. (xix) Introduce a voucher scheme for SMEs to use BDSs. (xx) Introduce a simplified tax system for SMEs. (xxi) Obtain World Trade Organization concessions for SME development. (xxii) Organize productivity enhancement programs for SMEs. (xxiii) Create industrial parks for SMEs in rural areas. (xxiv) Form industry clusters on a subsector basis. (xxv) Promote subcontracting with proper targeting to improve SMEs’ technological capabilities. (xxvi) Launch an awareness program on cleaner production targeted at SMEs, focusing on cost savings and efficiency benefits of cleaner production. (xxvii) Enhance the capability of government and private BDSs to assist SMEs in cleaner production and environmental management. Appendix 2 15 DETAILS AND STRUCTURE OF THE SRI LANKAN FINANCIAL SECTOR 1. The financial sector in Sri Lanka includes most of the institutional elements of a modern financial system, reflecting a broad range of reforms introduced since the early 1990s. The banking sector dominates in terms of assets but a range of other institutions offers financial services. At the end of June 2006, the Sri Lankan financial sector consisted of (i) 23 licensed commercial banks (LCBs), of which 11 are domestic private banks and 12 are foreign banks; (ii) 14 licensed specialized banks (LSBs), of which 6 are regional development banks, 1 national savings bank, 2 state-sponsored long-term lending institutions, 2 housing finance institutions, and 3 private savings and development banks; (iii) 28 registered finance companies; (iv) 13 insurance companies; and (v) 2 public pension funds. 2. From June 2005 to June 2006, total assets of the financial institutions increased by 18%, reaching SLRs3,706 billion which is 1.3 times the country’s gross domestic product (GDP). LCBs and LSBs, which accounted for 57.4% of the total assets of the financial system, continued to hold a dominant position in the financial sector. LCBs contributed 58.6% of the asset growth of the financial system (Table A2). Table A2.1: Total Assets and Deposit Liabilities of the Main Institutions in the Financial System June 2006a Financial Assets Deposit Liabilities Institution SLRs % SLRs % Share billion Share billion Central Bank of Sri Lanka 473.9 13.7 Institutions Regulated by the Central Bank 2,644.4 76.4 1,355.5 97.9 Deposit Taking Institutions 2,073.2 59.9 1,355.5 97.9 Licensed Commercial Banks 1,647.0 48.0 1,068.0 77.0 Licensed Specialized Banks 329.9 9.5 237.8 17.2 Registered Finance Companies 97.1 2.8 52.8 3.7 Other Institutions 571.2 16.5 — — Employees’ Provident Fundb 456.0 13.2 — — Primary Dealers 46.7 1.3 — — Specialized Leasing Companies 68.5 2.0 — — Institutions not Regulated by the Central Bank 343.7 9.9 29.0 2.1 Deposit Taking Institutions 32.0 0.9 29.0 2.1 Rural Banks 26.8 0.8 24.2 1.7 Thrift and Credit Cooperative Societies 5.2 0.2 4.8 0.3 Contractual Savings Institutions 280.2 8.1 — — Employees’ Trust Fund 62.5 1.8 — — Private Provident Funds 107.5 3.1 — — Insurance Companies 110.2 3.2 — — Other Specialized Financial Institutions 31.5 0.9 — — Merchant Banks 25.3 0.7 — — Venture Capital Companies 1.5 0.0 — — Unit Trusts 4.7 0.1 — — Total 3,462.0 100.0 1,384.5 100.0 a Provisional. b Administered by the Central Bank of Sri Lanka. Source: Central Bank of Sri Lanka 16 Appendix 2 3. Licensed Commercial Banks. The banking sector continued to be the dominant subsector, accounting for about 57.5% of the total assets of the financial system. LCBs accounted for the majority share, at 48% of the entire financial system’s assets and 77% of total banking sector assets (Table A2). 4. LCBs have broad business powers, and generally have subsidiaries and affiliates engaged in all areas of the financial services market. The three state-owned institutions— People’s Bank, Bank of Ceylon, and National Savings Bank—have the largest branch networks and number of deposit accounts. These institutions play an important role in the domestic banking sector, given their mandates to meet the policy objectives of providing financial services throughout the country and to target government priority sectors. 5. Major private commercial banks have widened their networks to cover almost the entire country, with four leading private commercial banks—Hatton National Bank, Commercial Bank of Ceylon, Seylon Bank, and Sampath Bank—accounting for 85% of the assets, 90% of the deposits, and 85% of the loans granted. While there are 11 foreign banks in Sri Lanka, only Hong Kong and Shanghai Banking Corporation (HSBC) with 10 branches and Standard Chartered with 9 branches, compete in the retail market. Collectively, these foreign-owned banks account for about 18% of commercial bank assets but only about 9% of loans—reflecting their much higher liquidity. However, these indicators understate the importance of foreign banks, as they carry out the majority of trade finance activities in the country. Many medium to large businesses in Sri Lanka have a relationship with at least one of the foreign-owned banks, mainly because of the need for letters of credit from banks with an international reputation. 6. The performance of LCBs improved further in 2006 in terms of growth of assets, expansion in delivery channels, improvements in risk management, risk absorption capacity, and use of information technology. The growth of total assets of domestic private banks and state-owned banks was 45.3% and 30.6%. Assets of foreign-owned banks grew at a rate of 24.2%. 7. Total assets grew by 31% in 2006, mainly attributed to the overall increase in loans and advances fuelled by expansion of credit by state banks and domestic private LCBs. State- owned LCBs recorded the highest growth in loans and advances of 44%, followed by foreign LCBs with growth of 25%. 8. Licensed Specialized Banks. The 14 LSBs, which all compete with commercial banks in some products, were established to provide specific services—often to address perceived market failures. Lending by LSBs was concentrated in housing, industrial, and financial sectors. 9. National Savings Bank is by far the largest LSB. It is the second largest deposit-taking institution in Sri Lanka, behind Bank of Ceylon. National Savings Bank operates largely as a deposit-taking institution, providing savings accounts through its 112 branches and investing about 80% of total assets in government debt. 10. LSBs also include development financing companies. Sri Lanka has two primary development finance companies—Development Finance Corporation of Ceylon (now DFCC) and National Development Bank (NDB). NDB and DFCC Bank were originally state-owned development finance institutions. They were privatized in the 1990s with the help of the Asian Development Bank (ADB), and the Government retained a minority stake in each institution. Both DFCC and NDB have evolved to become universal and cohesive financial services groups with the right to compete with commercial banks. They depend primarily on funding from Appendix 2 17 bilateral and multilateral agencies to support their development lending activities. Both NDB and DFCC have been highly profitable, and have much lower overhead costs than the commercial banks. DFCC, NDB, Commercial Bank, and Sampath Bank are primarily engaged in lending to the small- and medium-sized enterprise (SME) sector. In keeping with the needs of SMEs, DFCC and NDB have been scaling up training facilities and creating specialized branches or divisions geared to serving SMEs. 11. There are six regional development finance institutions—Wayamba, Kandurate, Sabaragamuwa, Ruhuma, Rajaratna, and Uva. These are mainly conduits for government subsidized credit programs, small business lending, and micro-lending. Collectively, they have 194 branches and assets of SLRs13.5 billion or just below 5% of the assets of all LSBs. There are also three small private savings and development banks including Samasa, established by thrift and credit societies, and the Ceylinco Group. The regional development finance institutions have been mainly ineffectual because of a lack of basic lending and other skills. The Government is considering merging the six regional institutions with the recently established Lanka Putra Bank to serve the SME sector better. However, it remains to be seen whether Lanka Putra Bank can fulfill its mandate. Experience from specialized SME banks in Sri Lanka and elsewhere points to their difficulties in delivering designed outcomes. As such, SME financing cannot be divorced from the mainstream financial institutions. 12. Performance Indicators. The banking sector in Sri Lanka is sounder and more resilient as a result of reforms undertaken over the past two decades. The benefits of reforms are borne out by banking sector performance indicators—the ratio of nonperforming loans (NPLs) to total loans has fallen, the capital adequacy ratio has increased, and profitability has risen. The average capital adequacy ratio of commercial banks increased from 8.6% in 2001 to 11.9% in 2006. NPLs,1 as a percentage of total loans, declined from 15.3% in 2001 to 6% in 2006 in the banking sector. The quality of banking supervision has improved since 2002, with all banks now being examined on-site at least once in a 2-year cycle. Together with increased depth in off-site analysis, this has greatly improved the ability of the Central Bank of Sri Lanka (CBSL) to identify weaknesses in banks. However, the implementation of remedial measures still lacks decisiveness and effectiveness. Prudential standards have been strengthened. 13. Specialized Leasing Companies. Specialized leasing companies (SLCs) recorded improved performance in 2006 in terms of profitability, capital, asset quality, and compliance with prudential regulations. There were 20 SLCs at the end of 2006. Of these, seven companies accounted for 83% of the total assets of SLCs. The total assets of SLCs increased by 25% from 2005 to 2006 to SLRs67 billion, while total finance leases increased by 11% to SLRs29 billion over the same period. 14. As SLCs are not permitted to accept deposits from the public, they are mainly dependent on bank borrowings or funds obtained through the issue of debt securities. Therefore, at the request of SLCs, CBSL has recommended an amendment to the Finance Leasing Act No. 56, 2000, to permit SLCs to mobilize funds through the issue of debt instruments. However, if SLCs are permitted to mobilize funds from the public, more prudential norms are required to safeguard the interests of investors in particular, and the stability of financial system in general. 15. The industry average of gearing ratio (debt to capital) of SLCs was about 4:1 against the permitted maximum ratio of 10:1, indicating a sound financial position. SLCs mainly depend on borrowings from banks and borrowings made against asset-backed securities. 1 This refers to gross NPLs ratio unless otherwise specified. 18 Appendix 2 16. In 2006, CBSL issued eight directions to SLCs relating to minimum capital, provision for bad and doubtful accommodation, single borrower limit, gearing ratio, accrued interest, reserve fund, financial statements, and corporate and operational information. 17. A high concentration of the leasing portfolio of SLCs is in vehicle financing, which accounts for 81%. However, the risks associated with possible defaults are largely mitigated by the nature of finance leases, where the vehicle is considered security and SLCs have absolute ownership of such vehicles. This concentration is not considered a major risk to the industry, as vehicles financed are used for public transport, goods transport, and personal use by a diverse clientele. However, the Central Bank of Sri Lanka is encouraging SLCs to diversify their leasing portfolios by providing facilities for purchase of capital equipment such as machinery. 18. Facilities granted in respect of leasing showed a declining trend from 2003 to 2006, and accounted for 64% of the total portfolio of all SLCs at the end of 2006. In contrast, facilities granted via hire purchase by SLCs increased and amounted to 19% of the total lease facility approvals of SLCs at the end of 2006. Tax benefits available for hire purchase largely contributed to this shift. More than 76% of the hire purchase facilities were in respect of vehicles. The combined share of both leasing and hire purchase continued to increase, and accounted for 83% of the total lease facility approvals of SLCs at the end of 2006. 19. Credit Risk. The level of credit risk of the SLC sector depends largely on the quality of assets, which is measured by the volume of NPLs and the NPL ratio. The NPL volumes reported by the seven largest SLCs have shown a decreasing trend from 2003 to 2006. The NPL ratio of SLCs, which continued to decline, reached 2.9% by 30 June 2007. The share of NPLs relating to leases continued to decline and reached 6.1% at the end of 2006. 20. Operational and other Risks. Sound operating systems, internal controls, and proper procedures are critically important to ensure the financial soundness of an institution. CBSL is planning to issue a code of corporate governance for voluntary compliance by SLCs. The SLCs are also required to report information on irregular lease facility approvals n a timely manner to the Credit Information Bureau. 21. Following a recommendation in the 2003 budget speech, SLCs are required to obtain ratings for debt instruments they issue to the public that are not guaranteed by a rated financial institution and each of which exceeds SLRs100 million. This limit was subsequently increased to SLRs200 million. 22. Overall Performance of SLCs. The SLC sector recorded satisfactory performance during 2006. Net profit before tax for 2006 amounted to SLRs1.3 billion and recorded 44% growth, compared with the previous year. All SLCs, except one, operated profitably during 2006. The overall profitability of SLCs was reflected in their return on assets (ROA) which increased from 3.3% in 2005 to 3.7% in 2006, and return on equity (ROE) which increased from 18.1% in 2005 to 19.3% in 2006. 23. Reform Challenges. Recent indicators point to improved bank soundness and performance in Sri Lanka. However, the reform process remains incomplete. Some segments of the banking sector and individual banks remain vulnerable. In particular, the performance of state-owned banks has generally been weaker than that of private and foreign banks. Improving the performance of state-owned banks should remain a high priority on the reform agenda. The key to financial sector development in Sri Lanka is continuation of the broad thrust of reforms that began in the 1990s to strengthen the government infrastructure and institutional framework, Appendix 2 19 while decreasing direct government intervention. Sustainable progress is dependent on further improvements in the legal framework for financial services and commercial transactions more generally, building infrastructure, and strengthening and enforcing prudential norms. 24. The high cost of credit remains a significant policy concern. The spread between deposit and lending rates has widened. However, improved margins are needed by weaker banks to earn enough to cover their accumulated loan losses and high operating expenses. Until weak banks (both state-owned and private sector) are restructured or exit the market, competition will be limited; margins will remain high; and the relatively more efficient banks, even if uncompetitive by international standards, will be highly profitable. 25. Major potential reform areas include the following: (i) completion of financial sector legal reforms, including a securitization bill and anti-money laundering statute; (ii) reform of the state- owned financial institutions, addressing not only asset quality and capital issues, but modernization so that Sri Lankans will be able to take full advantage of electronic payments, ATMs, and credit and debit cards; (iii) stringent enforcement of prudential standards for both public and private sector banks to avoid market distortions, higher costs for consumers, and extraordinary profits for well-run banks arising from weak banks’ lack of competitiveness; and (iv) addressing the infrastructure weakness for financial services, including the introduction of modern insolvency provisions through revision of the Companies Act (1982). 20 Appendix 3 THE LEASING SECTOR IN SRI LANKA A. Background 1. From the late 1970s, finance companies in Sri Lanka offered some leasing within their range of financial products. However, the major growth in finance leasing occurred following the formation of two specialized leasing companies (SLCs) sponsored by the International Finance Corporation—Lanka Orient Leasing Company (LOLC) in 1980 and Mercantile Leasing in 1983. At the end of 1985, these companies accounted for 77% of lease transactions.1 They were given tax holidays for 5 years from their formation (footnote 1). 2. Until 2001, leasing companies were largely unregulated and mainly specialist by nature. A new leasing act was introduced in 2001, permitting new leasing companies to be established as long as they met a minimum capital requirement of SLRs75 million ($0.75 million).2 This prompted a number of leasing companies to enter the industry. B. Portfolio Concentration 3. The Sri Lankan leasing sector has played an important role in the development of the transport sector, especially in rural areas. Passenger and commercial vehicles are the main category of assets financed by leasing, with a 70% share of the total portfolio in 2004 (down from 77% in 2003). Over 75% of leasing companies in Sri Lanka still concentrate on vehicle leasing. Only a few have diversified into other products such as financing warehouses, hospitals, educational institutions, and office equipment. Over 50% of leases were utilized to purchase secondhand vehicles. 4. The Central Bank of Sri Lanka (CBSL) is calling for the leasing industry to diversify into other areas and to target small- and medium-sized enterprise (SME) financing. The leasing of non-vehicle equipment has been hampered by the absence of a clear legal process with regard to the repossession of equipment, and the short commercial life of so much modern equipment (unlike vehicles, which have a ready secondhand value). However, it is typical for vehicles to dominate the leasing industry, outside a small number of developed markets. Factories often have less need for leasing in Sri Lanka, as they receive favorable credit lines from development finance institutions. However, machinery required for the tea industry is a potential avenue for development. C. Entry of Banks 5. Most of the recent entrants into the Sri Lankan leasing industry are subsidiaries of banks rather than specialist leasing companies. There is some resentment among specialist leasing companies to these banking entrants, which are considered fair-weather. Moreover, as independent specialist leasing companies are dependent on banks for funding, there is a concern that loan requests may be rejected for competitive motives. D. Legal Recourse and Repossession Laws 6. Litigation to recover bad debts is a protracted and costly process in Sri Lanka. An arbitration procedure designed to improve this process is not as successful as had been hoped, 1 ADB. 1986. A Study of Leasing in Selected Developing Member Countries. Singapore. 2 ADB. 2005, Financial Assessment Report for Sri Lanka. Manila. Appendix 3 21 with procedures often proving even more unwieldy and expensive.3 Leasing companies are excluded from Sri Lanka’s Debt Recovery Act (1990), which enables other financial institutions to repossess and sell securities without court intervention. Weaknesses in the guarantee and repossession laws hamper growth of the leasing sector, especially outside the better understood urban automotive sector. E. Regulation and Tax Considerations 7. CBSL issued seven directions in 2006 pertaining to minimum capital, provision for bad and doubtful lease facilities, single borrower limit, gearing ratio, reserve fund, financial statements, and corporate and operational information. Leasing companies also have moral obligations to follow best practices enunciated in the Sri Lanka Accounting/Auditing Standards Act No. 15, 1995, through a monitoring board. 8. The following regulatory/legal documents govern the leasing industry in Sri Lanka: (i) Inland revenue acts and other tax laws, including value-added tax (VAT). (ii) Regulations issued by the registrar of motor vehicles relating to leasing of vehicles. (iii) Procedures/arrangements commonly adopted by the Leasing Association of Sri Lanka; Credit Information Bureau of Sri Lanka; and Financial Ombudsman Scheme under the purview of Consumer Affairs Authority Act No. 9, 2003. (iv) Consumer Credit Act No. 29, 1982, in respect of hire purchase activities. (v) Credit agency functions under the Mortgage Act No. 6, 1949, and the Trust Receipt Ordinance No. 12, 1947. 9. Over recent years, there have been a number of significant changes in the fiscal treatment of leasing. A VAT regime was introduced in 2002, with the leasing sector subject to input and output taxes. The input and output taxes have been aligned at 15%. It has been argued that these changes have had the effect of making leases less competitive.4 10. In 2006, through the Leasing Association of Sri Lanka, SLCs requested CBSL to permit the mobilization of funds from the public via the issuance of debt instruments. CBSL agreed to this change and has proposed an amendment to the Finance Leasing Act No. 56, 2000. However, if SLCs are permitted to mobilize funds from the public, more prudential norms are required to safeguard the interests of investors in particular, and the stability of financial system in general. It is expected that the proposed changes to the Finance Leasing Act will allow SLCs to raise deposits from the public to come into effect in 2008. F. Tax Treatment of Leasing Transactions 11. The primary features of the tax treatment for leasing transactions are presented below. (i) Lessor can claim capital allowances on the cost of the leased asset. (ii) Lessee can claim rentals as allowable expenses. (iii) Generally, rentals are subject to VAT unless specifically exempted. (iv) Import and supply of leased assets are subject to VAT but the lessor can claim VAT input credit with some restrictions. 3 Paul, Lisa. 2007. World Leasing Yearbook 2005. United Kingdom. 4 Lanka Orix Leasing Company Annual Report. 2004. Chairman Statement on LOLC. Sri Lanka. 22 Appendix 3 (v) Leasing agreements and receipts are subject to stamp duty, debit tax on the procurement of leased assets, and income tax on profits. (vi) Economic service charge is payable on the turnover. (vii) Hire purchase interest and other fee-based incomes are liable to financial services VAT on the value addition. (viii) Financial service VAT on the value addition is at the rate of 20%. (ix) Asset disposal income, down payments, and all other receipts are subject to VAT. (x) Luxury motor vehicles and other luxury assets are subject to higher VAT rate of 30%. (xi) Capital allowance on plant and machinery is claimable in 8 years, which is a deterrent to invest through leasing. (xii) Deferred taxation treatment according to revised accounting standards has impacted leasing business. G. Issues and Concerns affecting the Leasing Sector 12. The Government of Sri Lanka is also considering changes in legislation that might hamper the industry: (i) reducing depreciation allowances from 25.1% to 12.5%; and (ii) charging leasing companies a tax of the higher of 1% of turnover or SLRs50 million ($0.5 million). The chair of LOLC argues that “increases in the VAT rate on leasing, special VAT rates on leasing companies, economic service charges, and changes to depreciation rates on vehicles and machinery are likely to make leasing an unattractive financing option to our core customer base of small- and medium-sized business enterprises. Furthermore, these fiscal disincentives could effectively undermine the collective efforts of the leasing companies to serve the small and medium entrepreneurs who are expected to make a substantial contribution to the national economy” (footnote 4) 13. The Sri Lankan leasing industry would benefit from improvements in the process of asset recovery, greater self-regulation, and the removal of VAT charges on leasing. 14. Vehicles leased in the Western Province and other areas have ended up in the North and East areas, which are under the control of the Tamil Tigers. Because of the escalated conflict, leasing companies are unable to visit these parts of the country to trace leased vehicles. 15. Commercial/development banks, motor vehicle agents/dealers, consumer goods importers, and independent entrepreneurs formed new leasing/finance companies—adding competition in the industry. As a result, the margins enjoyed by the leasing companies are expected to erode. 16. Machinery/equipment items have a very poor resale value. As a result, lessors face a very high credit risk in the event of a default. The proceeds of resale would be insufficient to cover the amount the lessor is due. This results in the lessor seeking legal remedies to mitigate losses. The lessor has to face severe difficulties to exercise its repossession rights. To overcome this issue, a suitable exclusion clause needs to be introduced to the criminal procedure code. Appendix 3 23 17. Under the current regulatory regime, the lessor does not have the comfort of initiating the action against the guarantors in the same action. Thus, an amendment needs to be introduced in the Finance Leasing Act to accommodate guarantors as well. 18. The principal Finance Leasing Act is to be amended to safeguard the interest of the lessor to prevent a lessee selling, disposing, or mortgaging the machinery/equipment item to third parties. 19. The import and supply of agricultural equipment/machinery is free of VAT. However, lease rentals on agricultural machinery are liable for VAT. As such, the lessee is very often a farmer who is expected to pay an additional 15% as VAT on the lease rental. Such an additional cost would not be payable on an alternative form of financing, such as a loan. H. Global Ranking of the Leasing Industry in Sri Lanka 20. According to the global leasing report,5 the Sri Lankan leasing industry has performed very satisfactorily in the last 2 years. It was the 42nd largest market (previous year 45th) as measured by new volume of business disbursements. I. Role of the Leasing Association of Sri Lanka 21. The Leasing Association of Sri Lanka was established in 1980. There are currently 53 member companies, chaired by the CEO of PLC. The principal objectives are to promote, foster, protect, safeguard, represent, and further the interests of the leasing industry; and to regulate and ensure the proper conduct of business by its members. 22. One of the most significant achievements of the Leasing Association in the recent past has been the agreement of CBSL to amend the Finance Leasing Act, enabling registered leasing companies to raise funds directly from the public. This is considered a major breakthrough, as it will reduce the reliance of leasing companies on bank funding and reduce the cost of raising capital by offering low-cost deposits to the public. 5 Paul, Lisa. 2007. World Leasing Yearbook 2007. United Kingdom. 24 Appendix 10 DEVELOPMENT IMPACT FRAMEWORK Design Performance Data Sources/Reporting Assumptions Summary Targets/Indicators Mechanisms and Risks Impact Assumptions • Percentage of GDP • Central Bank of The GDP composition contributed by the Sri Lanka • Increased access to of the Sri Lankan SME sector (outside finance from leasing economy is more the Western companies will lead to diversified (i.e., more province) rises from more SMEs receiving SMEs in more sectors the estimated 12% in lease facilities and contribute to a more 2007 to 20% in 5 expanding their role in diversified economy) years the economy • Percentage of • Stable or increased employment economic development contributed by SME in Sri Lanka sector rises from 75% in 2007 to 80% in 5 years Outcome Assumptions People’s Leasing • PLC’s and CLC’s • PLC’s and CLC’s • SME demand exists for Company Limited number of SME quarterly and annual lease facilities (PLC) and Commercial lessees increases financial statements • The two leasing Leasing Company (10% in the next • Reporting specifically companies do not Limited (CLC) provide 24 months) requested by ADB breach domestic increased, sustainable • PLC’s and CLC’s prudential leasing access to finance to credit quality further regulations SMEs in Sri Lanka improves; NPL level • No adverse economic of less than 2% for developments in PLC and 4% for CLC Sri Lanka • No regulatory changes for leasing • No other exogenous factors have a negative impact on the development of the leasing sector Outputs Assumptions 1. ADB provides • Loan requests • Quarterly and annual • Prevailing market secured loans to received by the financial statements of conditions are stable the leasing leasing companies the two leasing • All regulatory approvals in companies increased by 10% companies place for the per annum from • Reporting specifically disbursement of the ADB 2. PLC and CLC current levels requested by ADB loans operationalized the use of the ADB loans Appendix 10 25 Activities with Milestones Inputs 1.1 Provide PLC with a $10 million secured loan and CLC with a $7.5 million • ADB: $17.5 million secured loan by December 2007 • ADB enters into loan agreements with PLC and CLC 1.2 Operationalization of proceeds of the ADB loans by PLC and CLC (ongoing) • Origination of (new) client opportunities • Due diligence on clients • Completion of loan agreements with clients • Disbursement of loans to clients ADB = Asian Development Bank, CLC = Commercial Leasing Company Limited, GDP = gross domestic product, NPL = nonperforming loan, PLC = People’s Leasing Company Limited, ROE = return on equity, SME = small- and medium-sized enterprise. Source: Asian Development Bank. 26 Appendix 11 ENVIRONMENTAL MANAGEMENT SYSTEM GUIDELINES A. Environmental Safeguard Policy and Procedure 1. The borrowers will establish an environmental management system with the following guiding principles. (i) The borrowers shall establish an environmental screening classification system to identify and assess the environmental impact and issues (such as existing and potential environmental liability and financial implications related to such environmental impact and issues) associated with a potential customer of the borrower. (ii) The borrowers shall not finance a customer that conducts its business in a way that could have significant adverse environmental impact (and is therefore classified a category A project pursuant to the Environment Policy  of the Asian Development Bank [ADB]), involves resettlement, or affects indigenous people. (iii) Prior to making any loan, the borrowers shall themselves ascertain that their proposed customers are in compliance with applicable environmental laws and regulations and have no claims pending against them in connection with an environmental liability. The borrowers shall require their customers to submit copies of any environmental clearance issued by an environmental authority. (iv) The borrowers shall require their customers to comply at all times with applicable environmental laws and regulations. As promptly as possible after becoming aware of any borrower being in breach of applicable environmental laws and regulations, the borrowers shall use best efforts to cause their customers to implement a corrective action plan. (v) As part of the process of establishing an environmental management system, the borrowers will prepare and adopt an environmental policy statement to the effect that the borrowers will ensure compliance by lessees with all applicable environmental safeguard policy requirements of the relevant authorities within the relevant jurisdiction as well as all applicable ADB policies regarding the leased equipment. (vi) The borrowers will submit an annual report on its environmental performance to ADB. B. Staffing and Capacity Building 2. An appropriate number of staff members of the borrowers will be assigned to operate the environmental management system. 3. The borrowers will send at least one of its senior representatives to ADB-sponsored or approved environmental safeguard training. Appendix 12 27 SUMMARY POVERTY REDUCTION AND SOCIAL STRATEGY Country/Project Title: Sri Lanka: People’s Leasing Company Limited and Commercial Leasing Company Limited Lending/Financing Department/ SAGF/PSC Nonsovereign Modality: Division: M I. POVERTY ANALYSIS AND STRATEGY A. Linkages to the National Poverty Reduction Strategy and Country Partnership Strategy The Project supports the development goals of the Government and the Asian Development Bank (ADB) for Sri Lanka in the area of poverty reduction. B. Poverty Analysis Targeting Classification: General intervention 1. Key Issues. The Sri Lanka Leasing Facility seeks to enhance small- and medium-sized enterprise (SME) development by addressing barriers to growth faced by SMEs. The main thrust of the Project is to enhance access to finance of SMEs that normally do not have easy access to banking services and products. By adopting this approach, the Project will facilitate the development of a competitive SME sector that is capable of growth and expansion, and indirectly contribute to poverty reduction. Furthermore, a dynamic SME sector will generate employment, contribute to the reduction of direct government budget support to SMEs, and free up resources for infrastructure and social development. All these factors will lead to reduced poverty. 2. Design Features. Pro-poor. The Project creates employment opportunities for unskilled urban and rural labor and will thus support income generation. To facilitate good governance, the loan to People’s Leasing Company Limited (PLC) will help strengthen the company’s corporate governance structures by requiring the establishment of an audit and compensation committee and the inclusion of two independent directors on the board of PLC (on a best effort basis). This will contribute to the flow of improved services from the targeted lenders to the SMEs. By paying particular attention to the development of rural SMEs, the Project will improve the income of rural households and increase employment opportunities for rural residents, including women, by establishing new SMEs or expanding existing SMEs—thereby fostering social development. C. Poverty Impact Analysis for Policy-Based Lending Not applicable as the proposed intervention is not a policy loan. II. SOCIAL ANALYSIS AND STRATEGY A. Findings of Social Analysis The social analysis indicates that the SME sector accounts for 80–90% of the total number of enterprises and 75% of employment in Sri Lanka. 28 Appendix 12 B. Consultation and Participation 1. Provide a summary of the consultation and participation process during the project preparation. Extensive consultation meetings were held with the two borrowers, their major shareholders (including People’s Bank), Central Bank, Ministry of Finance, and the private sector. Furthermore, on-site due diligence was conducted with SMEs in Colombo as well as with the companies’ headquarters and branch networks. 2. What level of consultation and participation is envisaged during the project implementation and monitoring? Information sharing Consultation Collaborative decision making Empowerment 3. Was a consultation and participation plan prepared? Yes No C. Gender and Development 1. Key Issues. The Project addresses constraints faced by SMEs by paying particular attention to the development of rural/nonurban SMEs. By so doing, women who generally receive no wage income as household workers will be given the opportunity to be employed and to establish their own businesses. Furthermore, the improvement of the corporate governance structure of PLC, as a government-owned enterprise focusing on SME development, will also improve opportunities for women to gain access to skill development in both urban and rural areas 2. Key Actions. Measures included in the design to promote gender equality and women’s empowerment—access to and use of relevant services, resources, assets, or opportunities and participation in decision-making process. Gender plan Other actions/measures No action/measure III. SOCIAL SAFEGUARD ISSUES AND OTHER SOCIAL RISKS Issue/s Significant/Limited/ Strategy to Plan or Other Measures No Impact Address Included in Design Issue Involuntary Resettlement No impact Full Plan Short Plan Resettlement Framework No Action Indigenous Peoples No impact Plan Other Action Indigenous Peoples Framework No Action Appendix 12 29 Labor Employment opportunities PLC and Commercial Plan Labor retrenchment Leasing Company Other Action Core labor standards Limited will comply No Action with national labor standards. Affordability No impact Action No Action Other Risks and/or Vulnerabilities HIV/AIDS No impact Plan Human trafficking Other Action Others(conflict, political No Action instability, etc), please specify IV. MONITORING AND EVALUATION Are social indicators included in the design and monitoring framework to facilitate monitoring of social development activities and/or social impacts during project implementation? Yes No Monitoring on core labor standards will be maintained during project implementation.