Financial Investments

Debt Vs. Equity – A Case for FDI and Private Ownership

7 Mins read

Since the unprecedented crisis in the country in 2022, many people (experts as well as laymen) have weighed in on what ails Sri Lanka in terms of its governance and macroeconomic failings and missteps which eventually led to the collapse of the economy, the currency and default on its debt. Many have also commented/highlighted on the brain drain or migration of trained/skilled minds that are taking place or even accelerating. I like to dwell in this Note on a slightly different aspect/cause or focus on the same issue of the economy and its remedies purely from a Finance standpoint which I find not discussed widely enough in media and public/private fora. The principles discussed in this Note (# 7) holds for Corporates/Businesses and individuals as well.

As any student of Finance will tell you, study of a Degree in Finance will lead you to three main career paths. Regular Banking (mostly specializes in Debt), Asset or Fund Management and Merchant Banking or Corporate Finance. In this Note, I will attempt to look at Sri Lanka’s economic crisis and it’s possible solutions more from the vantage point of the Merchant Banker or purely from a financing point of view.

What are the essential or fundamental elements of a Country (or a Company) for it to efficiently or competitively function and thrive in a globalized economy?  (Sri Lanka in general and the government entities/SOEs in particular sadly lacks all these elements in varying degree.)

  1. A set of Physical Assets (investment)
  2. A group of People (human capital/Expertise/Know How)
  3. A governance/management Structure – Entrepreneurial Drive/Spirit
  4. A Plan/Skill/Ability to sell/export/market the output (goods or services)

I will mainly focus on the challenge of how to put together the essential Public Infrastructure Assets (or restructure existing set of Assets/SOEs) to revive economic activity and fuel growth as that’s the one which requires the bulk of financing. When one refers to Finance, what does that entail?

A set of Public Assets required to run a Country efficiently generally include highly capital intensive public infrastructure such as Roads/Highways, Sea Ports, Air Ports, Bridges, Power Generating/Distribution infrastructure, Irrigation Infrastructure, Storage/Logistics Infrastructure etc. etc. I like to highlight the fact that this type of infrastructure require some sort of Government (State and Local) involvement, at least at the initial stage as investment (finance) required are quite high, involves macro/national or strategic planning, land acquisition, very long gestation period etc. However, principles of financing such Projects are no different to Corporate Finance. In fact, at the country level, one may have even better options such as borrow at concessional rates or get equity participation by multilateral agencies (Ex. IFC etc.)

As any Accountant, Banker or Economist would point out, at the simplest/elementary level, a set of Assets (which gets recorded in a Balance Sheet) can be financed only by one of two ways; Equity/Own Capital or Debt/Borrowed Capital. (However, many hybrid combinations and sophisticated variations are available but that goes beyond the scope of this Note). Following is the basic equation of a Company Balance Sheet (In the case of a Country – Balance of Payments BoP).

TOTAL ASSETS = DEBT (Borrowed Capital) + EQUITY CAPITAL (Ownership)

At the national or macro level, Sri Lankan capital accumulation/formation or total Savings in the Banking system is around 17% of the GDP. For Sri Lanka to achieve an 8% real annual growth rate, the Country needs around 30% of GDP in capital investment (includes private investments in factories, housing, etc.) every year including in Public Infrastructure mostly undertaken by the Government. This leaves around a significant 13% of GDP (nearly $6-8 billion every year) gap/shortfall in Financing required to fuel the annual growth required to provide adequate employment opportunities etc. This capital can only come from outside the Country or from Savings of foreigners or citizens of other countries. Either we can borrow (Debt Financing) this Capital or try to attract Equity (FDI). From a macro perspective, it would be highly unwise to borrow in entirety such amounts from foreign sources. I would strongly argue the way to get out of our current predicament of unsustainable levels of government debt is aggressively canvassing for equity capital (foreign or local) in exchange for ownership transfer of government owned Assets thereby rebalancing the macro level Capital Mix or Structure.

In Finance, there’s an important concept called the Optimal Capital Structure (where Weighted Average Cost of Capital is the lowest). In simple terms, any balance sheet must have the right mixture/balance of Debt and Equity to balance the above equation. Its not desirable to either have too much Debt (borrowed capital) or too much Equity (own capital).

Debt in itself is not a bad thing as long as one knows the following;

  1. How much to borrow (as a % of the Balance Sheet and certainty/riskiness of Turnover/Income)
  2. On what terms (rate, repayment schedule, collateral required etc.)
  3. How or Where to deploy the funds (in productive activity that gives a better return etc.)

Equity (FDI) is usually better (specially in SL context where we have borrowed too much, on unfavourable terms etc and now unable to repay) and should be welcomed but ownership of those Assets will not be held by locals (ownership of existing set of Assets need to be handed over to the investor/new owner) which in Sri Lanka appear to be a controversial and divisive topic due to lack of proper understanding of basics of Finance. In other words purely from a Financing standpoint it would have been much better if Sri Lanka (or any other country in our situation) were to get $3 Bn in FDI in exchange for ownership in a Sri Lankan SOE than the EFF Facility (debt or borrowing) from the IMF. Bulk of the foreign reserves of the country should be equity (FDI, Remitances, Tourism Receipts and Export Proceeds) and not borrowed dollars/euros. That would have warranted lighting firecrackers and celebrations. (Admittedly, IMF Program with its monitoring mechanism sends other important positive signals to the international community of lenders and investors and governments)

 I like to state here a wise quote apparently made by late Mr.Upali Wijewardene; ” the ownership of a set of Assets is not important. What is important is having access to or the usership of those Assets”. This rationale/logic would apply equally to corporates or individuals. The reason is ownership comes with investing/blocking a sum of money (which always has opportunities elsewhere or opportunity cost) and if as Sri Lankan tax payers (or anyone else for that matter) can have access/usership to a business, service, infrastructure without doing the investment ourselves/utilizing our own equity funds, why not? Do we care who owns a business/set of assets?

I would take Hambantota Port (HIP) as an example which drew much condemnation and protest from sections of the Sri Lankan public against Foreign Investment/Ownership to illustrate the point. There should be no argument that the Chinese Investor has far better worldwide connections/network, port/logistics management expertise and deep pockets to continuously invest and improve the HIP and surrounding infrastructure than Sri Lanka Ports Authority or GoSL. The Security of the Port, Customs duties and Immigration is overseen by the GoSL. Only the commercial aspects are handled by the Chinese investor. SL exporters and importers have access to or the usership of a modern, efficient Harbour. I do not see any reason for Sri Lankans to complain (other than on the terms of the Sale which is a done deal). From a Finance stand point, it’s an Debt Equity swap. SLPA or GoSL balance sheet, Debt came down and ownership or management control on a lease was transferred to the Chinese party for 99 years. That Asset (or set of assets) can not be removed from our sovereign soil and thus comes under the SL Ports regulator. Whats more any income/profits derived from an efficient operation can be taxed and fees/levies charged by the SLPA/GoSL.

Many other examples such as Sri Lanka Telecom (SLT), Lanka Indian Oil Company can be given from our own country. Numerous examples can be given from all over the world specially India, Malaysia etc.. Remember, unlike when loans are taken, when foreign equity is committed to the country, the only forex outflow from the country is part of the dividends paid out to the owning entity and that is only when the business is profitable/thriving.

Ownership of Assets/Businesses change hands all the time on a daily basis (Ex. The Stock Markets) in the real world and that is nothing to fear. Companies regularly make in house or outsource decisions/choices. Individuals are often called upon to make own or hire/lease/rent choices. In fact, any one who understands the basics of Finance should welcome equity financing (as opposed to excessive debt financing) and welcome more and more FDI giving up government or private ownership (along with risks, challenges such as finding export markets/clients,  maintenance/upkeep and other headaches) and enjoy the benefits (usership and access) of efficiently run, thriving business operations (Power, Energy, Ports, Telecom, or whatever) by foreigners or even aliens functioning from our soil and servicing our people and paying their due taxes and fees.

If Sri Lanka were to fully open up the country and create the necessary conditions such as maintaining the rule of law and policy consistency, to attract/welcome foreign equity capital (FDI) and foreign human talent/know how/expertise ( Entrepreneurial, Managerial, Technical and Creative) like had been aggressively done and still being pursued in Dubai and Singapore and many other places like Panama, Malaysia, Thailand etc., Sri Lanka can not only come out of this crisis but also somewhat mitigate or even reverse the ill effects from the brain drain that is taking place. It would be a grave mistake to assume we Sri Lankans have all the requisite talent/expertise to run globally competitive businesses or can do everything better. Believe it or not, though those who are born and bred in Sri Lanka may be eager to migrate to the West looking for greener pastures, there are many in the West (and in other countries) with specific skills/talent/expertise we badly need and with Capital we lack who would consider moving here (or merely investing here) on a long term basis if the right conditions as mentioned above are created and available. Again, nothing for locals to fear as such opening up only would create vibrant, thriving businesses and a economy which in turn creates many employment and other opportunities for locals from which locals will gradually learn and acquire the know how/expertise over time not to mention the potential large tax revenues for the government.

So to reiterate, from an economic and finance point of view and indeed a common sense point of view, Ownership/Control is unimportant. Enjoy the access and usership while allowing the government to do its job of fostering competition, regulating and taxing these entities/businesses and pass on the benefits or to redistribute such revenues to the public/masses by enhancing and expanding, free health care and education, welfare programs and the like.

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Masters in Business Administration (MBA) with a concentration in International Business and Economics from University of Texas, Arlington, U.S.A., December 1994 | Bachelor of Science Degree in Business Administration with a major in Management from Hawaii Pacific University, Honolulu, Hawaii, 1991 | Certificate in Modern European Languages (German, French, English) from the Swiss School of Tourism, 1981 | Worked in the senior management at the Secretariat of the Securities and Exchange Commission of Sri Lanka (SEC) from September 2005 to February 2013 mainly as Director Surveillance and as an Equity Portfolio Manager at DFCC Bank and in the Seychelles | Currently retired from full time work but engaged in making Investments and Trading in Real Estate and at the Colombo Stock Exchange. Managing Director at Ethena Home Investments Ltd.. Also engaged in advisory work on Business Feasibility, Capital Restructuring, Investment Management etc.
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