Table of Contents
Most Sri Lankans, even some educated and better-informed people such as lawyers, engineers, and doctors, still put aside their residual income (amount left over after consumption and all other expenses) in traditional bank savings accounts and fixed deposits. The reason for this is accessibility, convenience and a sense of security a well established bank (which has a conspicuous physical presence) provides an average person as well as a lack of knowledge about alternative investment opportunities and how to access them. A majority of such “Deposits” offer poor returns, even negative returns, to Savers considering the relative risks involved and the underlying inflation forecast for the duration of the deposit. The returns for capital must be directly related to the level of risk pertaining to the borrowing institution. The basic principle is: Higher the risk, higher the return ought to be. Therefore the returns must at a minimum cover the inflation forecast for the period.
In a traditional economy, the banking system acts as the intermediary between the Savers (the general public and companies with excess cash) and the Borrowers (usually the corporate sector, business entities and the Government). This intermediation process in Sri Lanka is inefficient and thus tends to be a high cost to both the Saver and the Borrower. The difference between what one gets from banks for deposits and the lending rate of banks represent this cost. In Sri Lanka, this intermediation cost is high at approx. 5% to 7%.
In more developed economies where capital markets are fully functioning, the Saver and the Borrower have the opportunity to bypass the intermediary (i.e. banks) and thereby eliminate some costs associated with intermediation with benefits to both parties (Saver and Borrower). The Saver, who now can be called the Investor, can get a higher return while the cost to the Borrower can also be reduced.
Financial Intermediation Process (Regulated by the Central Bank)
Financial Disintermediation Process (Regulated by SEC)
Debt vs Equity
Most savings/investment vehicles (conversely financing methods of companies) can be categorized into two main types; Debt or Equity (or a derivative/hybrid thereon). Debt will yield a fixed periodic payment while in Equity, one takes a stake in a Corporate/Business entity. The risk of debt lies mainly on the fact that the institution, which takes your deposit or borrows from you through a Bill, Bond or a Note, will not be able to pay your interest and capital on time. To assess this risk there are two Rating Agencies in Sri Lanka which provide investors the comfort of professional assessment of risk.
Equity, through which an investor takes ownership position in a company shares in its rewards (profits) and risks (loses). If company goes bankrupt, equity investors may not recover any money. Therefore, investors in Equity take on a higher level of risk. Depending on an investors personal risk appetite, he or she may opt for an investment vehicle suited to his or her financial position and needs. In this article, we are primarily concerned with Debt instruments issued either by the Government or Private Companies.
Structure of Interest Rates
Interest rates on deposits and debt instruments are made up of several components. The main component is inflation. Credit risk (default risk), term risk, reinvestment rate risk, and liquidity risk are the other risks to compensate for which premia are added. The saver (investor) must get a real rate of return. Therefore, any interest rate, which at least does not cover the inflation forecast (expectation) for the term, is not attractive to a Saver or Investor. Alternately, an investor may take Sri Lanka’s long term average annual inflation, which is around 12%, and settle for a return above that. However, in Sri Lanka many Savers are willing (for lack of knowledge) to deposit their funds in bank savings accounts at 5-6% per annum when inflation is expected to be substantially above that. This is highly disadvantageous to savers as they end up with negative returns and the Sri Lankan saver needs to be educated on the alternatives available.
The way forward is to develop many more capital market mechanisms and instruments, which can bypass the traditional banking systems (disintermediation) and facilitate Investors and Borrowers to meet and transact their business directly. The result will be better returns for Investors and low borrowing cost for Companies. Currently, investors have an opportunity to invest in Treasury Bills and Bonds, which yields credit risk free returns covering expected short run inflation and certainly the long run average which is 12%. The disintermediation process will eventually force the banks to pay returns which at least cover inflation to their depositors.
Time Value of Money and Compounding Interest
In an economy which has well organized financial markets Money has a time value. Money should not be idle (i.e. without being properly deployed earning interest, dividends etc. to its owner) even for one day. Interest is usually agreed or fixed for a period of 3, 6, or 12 months or longer periods. When such instruments/deposits mature the interest for the previous period is added to the capital that is rolled over. This is called the compounding effect and as shown below, makes a huge difference to the total capital over long periods of time and at higher rates of interest.
|Interest Rate per annum
|Value of 100,000 rupees in 10 years
|Value of 100,000 rupees in 15 years
|207,890 (2 times)
|259,370 (2.5 times)
|417,720 (4 times)
|404,560 (4 times)
|813,710 (8 times)
Longer the period involved, the effect of getting consistent higher annual rate for ones savings becomes even more pronounced.
Available Opportunities In The Market Place
The Treasury Bills in Sri Lanka, where the Government of Sri Lanka issues Debt instruments to borrow directly from potential savers/investors, is the most visible example of this disintermediation process. In terms of returns, the Treasury Bills which are free from credit/default risk currently yield approx. 18% per annum. Compare that with approx. 6% or 7% yield for one-year saving deposit with a bank (which is a higher risk than Treasury Bills). So why not invest in Treasury Bills or Repurchase agreements (backed by Treasury Bills)? You, the saver, have a right to demand from your bank your desire to invest in Treasury Bills.
Similarly, there are other capital market debt instruments issued by Private Companies that one can find which would give a higher return for assuming a higher risk than that of the Government. Look for a rating given by one of the two Rating Agencies to avoid very high risk instruments or seek advise from a financial professional when unsure.
And just like any other product or service you intend purchasing, compare returns you are offered by financial institutions which carry similar risks or financial products which carry similar risks. Make sure you compare oranges with oranges. With Government Treasury bills, you have no comparison as all other institutions (ie all commercial banks) and debt instruments are of higher risk.