BARRIERS TO LONG-TERM FINANCING AT AFFORDABLE RATES:
INTRODUCING A NATIONAL DEVELOPMENT BANK TO SUPPORT TIMOR-LESTE PRIVATE SECTOR DEVELOPMENT
*Cosme Da Costa Araujo
May 2017
INTRODUCTION
More than a decade since the restoration of its independence in May 2002, Timor-Leste is slowly moving away from the ashes of destruction that devastated the country in 1999 and the internal conflict that nearly brought the country into a civil war in 2006. The recent presidential election held in March 2017 seems to confirm that Timor-Leste has graduated from a fragile state and is striving towards a stable and resilient state.
More than a decade since the restoration of its independence in May 2002, Timor-Leste is slowly moving away from the ashes of destruction that devastated the country in 1999 and the internal conflict that nearly brought the country into a civil war in 2006. The recent presidential election held in March 2017 seems to confirm that Timor-Leste has graduated from a fragile state and is striving towards a stable and resilient state.
Timor-Leste aspires to transition from a low income to upper middle income country, with a healthy, well-educated and prosperous population by 2030 (GOTL, 2011). The Strategic Development Plan (SDP) stresses the importance of a sustainable non-oil economy led by the private sector to create employment and income. Since the SDP was introduced in 2011, significant progress has been made and the country is seen to be “moving at the right direction” (Asia Foundation, 2013). Poverty, while still a high proportion of the population, has been significantly reduced by almost 9% from 50.4% in 2007 to just under 42% in 2014. The multidimensional poverty measures also show improvement in access to basic services, education, health, housing, sanitation facilities and drinking water (MOF & World Bank, 2016).
In term of the economic development, Timor-Leste has experienced high economic growth in the last decade. The non-oil GDP growth, which nets off the oil and gas activities, averages about 8.6% per year over 2007-2014. Such a high growth rate has been driven primarily by the increase in the government’s expenditure, with a small contribution from household consumption and private sector investment (MOF, 2017). Despite private sector investment is growing, its contribution measured by its share of total GDP and contribution to domestic tax revenue is still very limited. The oil and gas activities still account for more than 60% of the total real GDP in 2014 (MOF, 2017). Domestic revenue only makes up about a quarter of the actual total revenues received in 2015 (MOF, 2017).
In terms of employment, about 63,300 people are formally employed in Timor-Leste businesses in 2015 (MOF, 2015). About 34,300 jobs are in the public sector. The private sector absorbs less than 13% of the country’s total labor force of 213,000 people. Of the total 10,135 local and international businesses who have registered with the SERVE, the one-stop-shop for business registration and licensing, the majority of them are small, locally-owned, one-and-two person shareholder companies with many of them are set up to cater for government’s projects. Productive areas such as agriculture and tourism or services are the least invested sectors, even though they employ most of the people, with a relative employment share of more than 50% (MOF & SEPFOPE, 2013). The bulk of this is in subsistent agriculture.
It is agreed that private sector investment in productive economic sectors is needed to generate new sources of income and to create jobs for the country’s underemployed and expanding population (ADB, 2015). Despite the significant progress it has made thus far, long-term financing at affordable rates is one of the barriers preventing Timor-Leste’s private sector from reaching its full potential and achieving the country’s SDP’s targets.
This paper intends to present barriers that prevent Timor-Leste private sector from accessing long-term financing at affordable rates. It will argue in favor of introducing a National Development Bank and propose mechanisms to remove the barriers to financing. In doing so, this paper will be structured as follow. Firstly, it will present the barriers that prevent private sector from accessing to financing. Secondly, it will propose the establishment of a National Development Bank as one of the solutions to provide access to financing. Thirdly, it will provide some mitigating factors to avoid the mistakes made by other similar national development banks. Lastly, it will conclude with recommendations for policy action.
BARRIERS TO LONG-TERM FINANCING AT AFFORDABLE RATES
Timor-Leste’s banking and financing sector is small and relatively new. Five commercials banks are currently operating in the country. They include the ANZ Bank, Bank Mandiri, Banco Nacional Ultramarino, the government-owned Banco Nacional de Comércio de Timor-Leste (National Commercial Bank of Timor-Leste, or BNCTL) and the recently established Indonesian government’s Bank Rakyat Indonesia (BRI). Two microfinance institutions (Moris Rasik and Tuba Rai Metin – Kaibauk Investment) offer small loans to residents in rural areas. There are three licensed insurance companies (National Insurance of Timor-Leste, SinarMas and Federal Insurance Timor (BCTL, 2016). There are at least nine money transfer operators and 76 credit unions (UNDP, 2016). There are no equity or bond markets issued by both public and private investors (ADB, 2014).
Total assets in the banking system at the end of 2016 are about US$1.1 billion, an increase of 24% from the previous year (blue column in Table 1). Commercial banks own about 73% of these assets. Growth in credit to the private sector lags well behind deposit growth. While the liquidity in the banking system remains very high, credit to private sector remains flat at less than US$150 million or 14% of the total assets (red column in Table 1).
Timor-Leste’s credit to the private sector is 15% of GDP in 2015 (IMF, 2016). This is significantly below the average for lower middle income countries at 36.6% (ADB, 2015), 68% of GDP in 2014 for Pacific island small states and 131% of GDP in 2014 for East Asia and Pacific developing countries (IMF, 2016).
Banks are engaging in credit rationing. They primarily serve international organizations and their staff, businesses and nationals from their respective home countries, and sectors that rely on government contracts and public investments (ADB, 2015). The banks require high collateral, a credit history and official financial reports which many businesses in Timor-Leste simply do not have (UNDP, 2016). Excessive deposits are placed offshore rather than loaned out to finance the development of the domestic economy. The IMF Article IV for 2016 remarks that “the soundness of bank’s lending remains fundamental, but the strong deposit growth and continued decline in loans-to-deposits ratio suggests that banks are falling short in their role of financial intermediation” (IMF, 2016). The spread between the interest rate charged by banks on its loans relative to deposits stands at 13% in 2015 (BCTL, 2016). The average maturity of loans is about two years, making it difficult for businesses to make meaningful long-term investments. Microfinance institutions do lend but offer small loans with very high rates, reportedly at an effective rate of 30% (UNDP, 2016).
Banks see Timor-Leste’s businesses as representing high credit risk. There are difficulties with providing collateral and recovery, including uncertainty of title for land that could otherwise serve as collateral; there is a lack of financial literacy and weak business skills; and in terms of the legal system, there is a lack of clarity around creating and enforcing security interests in movable assets, an outdated bankruptcy framework and weak contract enforcement.
ESTABLISHING A NATIONAL DEVELOPMENT BANK TO REMOVE THE BARRIERS TO ACCESING LONG-TERM FINANCING AT AFFORDABLE RATES
n response to the lack of long-term financing for domestic non-oil investments, the government has introduced a number of measures including the recent approval of credit guarantee scheme (CGS) for small and medium-sized enterprises. It intends to facilitate credit access to commercial companies with at least 75% Timorese ownership and to self-employed Timorese people. The government will share the risk of credit granted by commercial banks up to a maximum of 70% of the loans that meets the legal requirements (GOTL, 2017). While the detail of the policy still remains to be seen, the CGS without being reciprocated by the banks in the form of lower interest rates; privates sector will continue to expose to high borrowing costs, the credit risk is shifted to the government, and banks high profit margin will increase further as they will likely to lend out more for a 70% guaranteed recovery for default. The government should include a provision in CGS that states that the eligibility for CGS claim should be conditioned upon interest rates on SME loans not exceeding certain percent per annum.
The best alternative solution is for the government to establish a National Development Bank (NDB). The SDP envisages the NDB to provide credit to the private sector beyond the capacity and willingness of other financial institutions. It focuses on lending to address unmet demand for credit and provide the strategic direction of the country in particular the growth of private sector and the development of domestic financial markets (GOTL, 2011). The main role of the NDB is to provide long-term finance at affordable rates to the private sector. In doing so, the NDB is mandated to allocate a big proportion of its assets for loans; provide subsidized interest rates; be actively involved in the management of the businesses taking out loans; provide smalls loans to microfinance institutions; co-invest with foreign and local investors; and partner with the government to create conditions for conception of a domestic financial market.
Mandated loans
The NDB is mandated to allocate a big proportion of its assets to provide loans to the private sector. The experience of the government-owned BCNTL shows that it has failed to achieve its implicit mission of providing financing to the domestic private sector. Instead, it follows the path of other foreign commercial banks. A similar policy is adopted in China and the Philippines. In China, with the introduction of the Small and Medium Enterprise Support Act in 2002, commercial banks are called to devote a higher proportion of their loan portfolio to the SME lending (ADB, 2014). In the Philippines, the mandated credit program known as MSME Magna Carta was introduced to improve financial access to MSMES, which accounts for 99.6% of total firms and 61% of total employment in the Philippines (Khor, Jacildo & Tacneng, 2015).
Subsidized interest rate
With the average interest rate charged by the banks at around 15%, and a 30% effective rate charged by microfinance institutions, the NDB can offer an alternative solution with a subsidized interest rate that is reasonably affordable. Low interest rates will allow businesses to undertake sizeable loans to finance long-term projects. The experience of South Korea in its early years of development shows that when interest rates are set below market rates, firms are able to develop capital intensive production; this enabled South Korea to gain a competitive advantage for exporting (Dana, 2007). The subsidized interest will also force other banks to follow suit or else lose their markets and profits.
Active involvement in the management of business
Instead of acting as debtor to businesses, the NDB can also take part in the management of the businesses as a shareholder of the businesses. In doing so, it can impart its skills and knowledge of financial management, one thing that many businesses in Timor-Leste are lacking. This role enables the NDB to promote “local champions” that are competitive domestically and internationally.
Provide small loans to microfinance institutions
The NDB also provides loans to microfinance institutions. Taking advantage of their extensive networks in rural areas, the NDB can thereby indirectly help out small and medium size businesses in rural areas. Part of the loan condition for the microfinance institutions is that they are required to charge their clients a pre-determined interest rate or a similar subsidized interest rate as if these loans are taken directly from the NDB.
Co-invest with local and foreign investors
Local and international investors are hesitant to invest in Timor-Leste. For a number of big projects such as Tibar Bay Port and TL Cement, the Government is forced to take part in the joint-venture. Rather than involve the limited resources and legal constraints of the public sector, the better resourced NDB could instead co-invest with local and foreign investors in these commercially-based investments. It can be a passive investor by simply providing loans or alternatively actively involved in the operation and management of the projects. The NDB can act as an agent to attract foreign direct investment into the country. It can perform similar roles to the Singaporean TEMASEK.
Helping financial integration and financial market development
The NDB capital will be financed through transfers from the state budget and involve equity partners including Timorese citizens and other commercial banks and financial institutions. It helps to improve Timor-Leste’s financial deepening, financial integration and financial market development through the issuance of bonds and shares. Financial markets will facilitate local businesses to have access to affordable rates like those offered worldwide.
MITIGATING FACTORS
The typical concerns about the creation of a NDB are (1) high levels of non-performing loans; (2) lack of skills to do credit assessment and risk management; (3) politically-connected lending; (4) inadequate banking supervision; (4) misallocation of resources; (5) subversion of the private banking system and (6) the government becoming the ultimate bearer of all the risk.
The NDB will be operating on a commercial basis at a competitive level with other banks. Therefore, prudential policies will be established to ensure that loans are not recklessly given but are carefully designed and given to businesses involved in productive sectors and projects that will generate continuous positive cash flows over the long-run. All these processes will ensure that the past experience of high-nonperforming loan is limited and preferably eliminated, independently run by professional apolitical staff with a strong adherence to bank rules and regulations under the Central Bank supervision. The Bank will be managed by an expert and independent board of directors (GOTL, 2011). The board will insulate the National Development Bank from non-commercial pressures. The Bank will become profitable within a reasonable period of time to preserve its capital.
CONCLUSION
Timor-Leste’s private sector development is not yet achieving its full potential and falls short of the SDP’s targets. The barriers to long-term financing at affordable rates is identified as one of the obstacles that holds back Timor-Leste’s private sector development. Timor-Leste’s banking system has high liquidity, but the amount of credit provided to the private sector remains flat at around 13% of the total assets. The banks’ reluctance to lend is due to the difficulties with collateral and recovery, risk assessment, land title, and deficiencies in the country’s legal system.
To address the lack of long-term financing for businesses and develop the domestic non-oil economy, the government needs to establish a national development bank. The NDB will set aside a large proportion of its assets for loans, provide subsidized interest rates, take part in the management of businesses taking out loans, provide small loans to microfinance institutions, co-invest with foreign and local investors and work with the government to develop a financial market. The NDB will take into account and put in place necessary mitigating factors to avoid the failures of other NDBs.
ADB, (2014), Access to Finance – Microfinance in the People’s Republic of China.
Asian Development Bank, (2013), Timor-Leste Public Opinion Poll – September 2013, Dili, Timor-Leste.
Asian Development Bank, (2015), Growing the Non-Oil Economy – a Private Sector Assessment for Timor-Leste (https://www.adb.org/sites/default/files/institutional-document/161516/tim-growing-non-oil-economy.pdf).
BCTL, (2016), Relatório Anual – Ano Financeiro 2016, Dili, Timor-Leste, (https://www.bancocentral.tl/en/go/bctl-annual-report).
Dana, L-P, (2007), Asian Models of Entrepreneurship: from the Indian Union and the Kingdom of Nepal to the Japanese Archipelago – Context, Policy, and Practice, World Scientific, New Zealand.
GOTL, (2011), Timor-Leste Strategic Development Plan 2011-2030, Timor-Leste, (http://timor-leste.gov.tl/wp-content/uploads/2011/07/Timor-Leste-Strategic-Plan-2011-20301.pdf).
GOTL, (2017), Council of Ministers Meeting on May 30th 2017, Dili, Timor-Leste, (http://timor-leste.gov.tl/?p=18106&lang=en)
IMF, (2016), The 2016 Article IV Consultation for Democratic Republic of Timor-Leste.
Khor, N, Jacildo, R., & Tacneng, R., (2015), Assessing mandated credit programs: case study of the Magna Carta in the Philippines, the Asian Development Bank, November 2015, (https://www.adb.org/sites/default/files/publication/176822/ewp-463.pdf).
MOF & SEPFOPE, (2013), Timor-Leste Labor Force Survey 2013, Timor-Leste, (http://www.statistics.gov.tl/wp-content/uploads/2015/04/LFS_2013_ENGLISH_VERSION.pdf).
MOF & World Bank, (2016), Poverty in Timor-Leste 2014, (https://openknowledge.worldbank.org/bitstream/handle/10986/25269/108735-REVISED-PUBLIC-012-TL-REPORT-R02.pdf?sequence=1&isAllowed=y).
MOF, (2017), Budget Book 1, Government Budget for 2017, Dili, Timor-Leste, (https://www.mof.gov.tl/category/documents-and-forms/budget-documents/budget-current/?lang=en).
MOF, (2016), Business Activity Survey for 2016, General Directorate of Statistic, Dili, Timor-Leste.
UNDP, (2016), Mobilizing Social Business to Accelerate MDGs Achievement – Access to Finance, Dili, Timor-Leste, (http://www.tl.undp.org/content/dam/timorleste/docs/reports/TL_PRE_SocialBusinessProdoc.pdf).
