28547 .s LESOTHO Financial Sector Review APRIL 2004 WHITE COVER The World Bank Financial Sector Division Africa Region FILE PY o!lo t rn CURRENCY EQUIVALENTS (Exchange Rate Monthly Average July 2003) Currency Unit = Lesotho Loti Lesotho Loti = US$0.132 ACRONYMS ADB African Development Bank AGOA African Growth Opportunity Act BEDCO Basotho Enterprise Development Corporation BNRSCAP Broad National Rural Savings and Agricultural Credit Policy CBL Central Bank of Lesotho CDC Commonwealth Development Corporation CIDA Canadian International Development Agency CIDA Canadian International Development Agency CMA Common Monetary Area DEG Deutsche Entwicklungs Gesellschaft DFI's Development Finance Institutions DFID Department for International Development (UK) EU European Union GDP Gross Domestic Product GNP Gross National Product GNS Gross National Saving GOL Government of Lesotho GTZ Gesellschaft fir Technische Zusammenarbert (Germany) IFAD International Fund for Agricultural Development IMF International Monetary Fund LADB Lesotho Agricultural Development Bank LAR Local Asset Requirement LHWP Lesotho Highlands Water Project LNDC Lesotho National Development Corporation LNGIC Lesotho National General Insurance LNIC Lesotho National Insurance Company LNLI Lesotho National Life Insurance LP Lesotho Post LPB Lesotho Postal Bank LRA Lesotho Revenue Authority MDP Ministry of Development Planning MDPF Miners' Deferred Pay Fund MFI's Microfinance Institutions MoF Ministry of Finance MSE's Micro and Small Enterprises MSME Micro, Small and Medium Enterprises MTI Ministry of Trade and Industry NBFI's Non Bank Financial Institution NGO Non-Governmental Organization NPL's Non Performing Loans PRSP: Poverty Reduction Strategic Program RFESP Rural Finance and Enterprise Support Project ROSCA Rotating Savings and Credit Associations RSA Republic of South Africa SACU Southern Africa Customs Union SADC Southern Africa Development Community SME Small and Medium Enterprises UNDP United Nations Development Program UNIDO United Nation Industrial Development Organization VAT Value Added Tax Table of Contents FIGURES ................ 3 P R E F A C E ...................................................................5 EXECUTIVE SUMMARY ........................................................I CHAPTER ONE ..............................................................1 MACRO-FINANCIAL FRAMEWORK AND STRUCTURE OF THE FINANCIAL SYSTEM .........1 A. MACROECONOMIC OVERVIEW ...........................................1 B. MONETARY AND CREDIT DEVELOPMENTS .................................... 3 C. STRUCTURE OF INTEREST RATES ........................................ 5 D. SAVINGS AND INVESTMENT ............................................. 6 E. FINANCIAL DEEPENING .....................................6..........6 F. MONETARY POLICY AND THE FINANCIAL' SYSTEM ......................... 7 G. FINANCIAL POLICIES ................................................... 9 H. RELATIONSHIPS WITH SOUTH AFRICA .................................... 11 CHAPTER Two .............................................................13 THE COMMERCIAL BANKING SECTOR .......................................... 13 A. BACKGROUND ....................................................... 13 B. STRUCTURE AND RECENT PERFORMANCE OF THE BANKING SYSTEM ...........14 C. SELECTED ISSUES AND RECOMMENDATIONS ...............................19 D. RECOMMENDATIONS ..................................................20 CHAPTER THREE ............................................................25 NON BANK FINANCIAL INSTITUTIONS ...........................................25 A. INTRODUCTION ...................................................... 25 B. THE INSURANCE INDUSTRY ............................................25 C. DEVELOPMENT FINANCE INSTITUTIONS ..................................29 E. OTHER NON-BANK FINANCIAL INSTITUTIONS ..............................36 CHAPTER FOUR .............................................................39 FINANCE FOR MICRO, SMALL AND MEDIUM ENTERPRISES ......................... 39 A. OVERVIEW OF THE MICRO, SMALL AND MEDIUM ENTERPRISES IN LESOTHO . 39 B. FINANCIAL SERVICES FOR MSMES IN LESOTHO ...........................40 C. THE REGULATORY AND BUSINESS ENVIRONMENT ..........................49 D. DEVELOPMENTAL RECOMMENDATIONS ..................................52 ANNEXES ..................................................................56 Annex 1: List of Recommendations ....................................56 Annex 2: Nedbank Balance Sheet 1999-2002 (M million and percent) .......... 60 Annex 3: Nedbank Income Statement 1999-2002 (M million and percent) .......61 Annex 4: Standard Bank Balance Sheet 1999-2002 (M million and percent) ......62 Annex 5: Standard Bank Income Statement (M million and percent) ........... 63 Annex 6: Lesotho Bank Balance Sheet (M million and percent) ...............64 Annex 7: Lesotho Bank Income Statement (M million and percent) ............ 65 FIGURES Figure 1: T-bill rates in Lesotho and South Africa (1997-2002) ...................8 Figure 2: Evolution of financial development indicators (1997-2001) .............14 Figure 3: Interest rates in Lesotho and RSA (1997-2002) ....................... 21 TABLES Table 1: Structure of the Lesotho's Financial System Total Assets ii Table 2: Selected Macroeconomic Indicators (1996-2002) 2 Table 3: Financing Domestic Government Debt 3 Table 4: Monetary Developments, 1996-2001 (excluding Rand in circulation) 4 Table 5: Domestic Credit Developments, 1996-2001 5 Table 6: Selected Interest Rates (%) 6 Table 7: Indicators of Financial Depth 7 Table 8: Lesotho: Balance Sheet For The Banking System 1999-2002 15 Table 9: Sectoral distribution of bank loans (Million Maloti and percent) 17 Table 10: Summary Income Statement of Lesotho's Banks (1999-2002) 18 Table 11: Total Assets And Insurance Penetration In Lesotho 26 Table 12: LNDC - Unconsolidated Balance Sheet (1999-2002) (000 Maloti) 30 Table 13: LNDC Financial Statements (1999-2002) (Maloti 000) 32 Table 14: BEDCO-Balance Sheet (1997-2000) (000 Maloti) 34 Table 15: BEDCO- Selected Income Statement Items (1997-2000) (000 Maloti) 34 Table 16: Balance Sheet of SBL Unit Trust (000 Maloti) 36 PREFACE This report is a review of the Lesotho's Financial System covering: (i) macro-financial environment; (ii) safety and soundness of the banking system; (iii) Non Bank Financial Institutions; and (iv) microfinance and finance for Small and Medium Enterprises. This report was based on data and other information collected during a March 2003 mission. The review had three major objectives: * To assess the safety and soundness of selected sectors in the financial system, * To evaluate major constraints facing the financial system and its ability to support private sector development, and * To formulate actions and policies to address these constraints. The report is presented in four Chapters: Chapter One (Macro-financial Environment and structure of the financial system) briefly covers a review of macro-financial issues and the structure of the financial system; Chapter two (Banking Institutions) addresses: i) the banking system; ii) performance of the banking system; and iii) key issues facing the banking system; Chapter three (Non-Bank Financial Institutions) covers : i) the insurance sector; ii) development finance institutions; and iii) term finance and leasing; and Chapter four (Finance for Micro, Small and Medium Enterprises) includes : (i) an overview of the MSME sector in Lesotho; (ii) An analysis of Micro and SME financial services; and (iii) policy, regulatory, and supervisory issues. Each chapter contains recommendations for addressing key issues facing the sector. A Statistical Annex contains relevant data for all the chapters. This report is an informal study focused on updating knowledge on issues facing Lesotho's financial sector. There are, therefore, significant constraints on its scope and it does not, for example, discuss a number of broader issues that relate to Lesotho's relationship to South Africa's financial sector and the Common Monetary Area (CMA) which would require a study of other countries of the common monetary area as well as Lesotho; i.e., i) whether or not Lesotho should continue to maintain its currency separate from the South African Rand; and ii) whether or not the Central Bank of Lesotho should subcontract some supervision functions to South African supervisory entities because of economy of scale considerations. This report was prepared under the oversight of Gerard Byam (Sector Manager, AFTFS) and James Sackey (Country Program Coordinator, Lesotho). Contributors to the report were: Djibrilla A. Issa (Financial Sector Specialist/ream Leader, AFTFS), Abayomi A. Alawode (Senior Economist, AFTFS), Paul Murgatroyd (Consultant), Marylyn S. Manalo (Operations Officer, AFTPS) and Edmund Motsheki (Operations Analyst, AFTCO1) who provided support from the Lesotho Liaison Office. Rona Cook (AFTPFS) Theresia Rasethunts'a (AFTCO1) and Fatiha Amar (AFTPFS) provided assistance. Jo Ann Paulson (Lead Economist, FSD), Andre Ryba (Lead Banking Sector Specialist, AFTFS) and Ahmet Soylemezoglu (Senior Financial Sector Specialist, AFTFS) served as Peer Reviewers for the report. This report has benefited from the excellent cooperation of officials of the Central Bank of Lesotho, (CBL), the Lesotho PRSP Committee, the High Court of Justice, the Ministry of Development Planning (MDP), the Ministry of Finance (MoF), as well as numerous individuals at various bank and non-bank financial institutions in Maseru. EXECUTIVE SUMMARY A. General Background 1. Lesotho's economy is closely linked with South Africa and the commercial banking sector has traditionally operated in a free market environment where there has been a virtually free flow of funds between the two countries. Lesotho is a member of the Southern African Customs Union (SACU) and the Common Monetary Area (CMA), and shares in the customs receipts collected by SACU. These relationships entail the ability to transfer funds to take advantage of interest rate differentials under situations of excess liquidity, cross border investment opportunities, and trade finance transactions. Lesotho's economy is based on limited agricultural and pastoral production, light manufacturing (clothing, textile, and leather) and remittances from Lesotho mineworkers in South Africa and more recently, by the receipt of royalties for supply of water to the Republic of South Africa (RSA) under the Lesotho Highland Water Project. 2. Lesotho's economic performance, which was favorable in the early 1990's began to deteriorate in the late 1990's with the winding down of activity in Phase IA of the LHWP, a reduction in miners' remittances from abroad and, subsequently, the political disturbances of September 1998. As a result, real GDP declined by almost 4 percent in fiscal year 1998/1999. 3. However, a surge in foreign direct investment in manufacturing to take advantage of regional trade arrangements and more recently the US African Growth Opportunity Act (AGOA) is a positive development which has boosted employment and export revenue. Today, Lesotho's most important challenge is to retain foreign investors after the phasing out of trade privileges and to attract larger amounts of foreign direct investment, diversify it away from its overwhelming reliance on one major activity, and deepen its roots in the economy through better integration with the domestic private sector. To do so, it must develop more private sector competition (local and foreign), exploit more fully its structural complementarities with the South African economy2 and build a more conducive pro-business investment environment by increasing capacity and efficiency of its financial services. B. Financial System Structure and Performance 4. This report examines the role of the financial sector in supporting private sector-led growth and Lesotho's poverty reduction strategy. The financial sector is very small and undiversified. Apart from the central bank, the majority of the sector is privately owned and operated in an economy which is relatively free of economic distortions. The structure of Lesotho's financial sector is shown in Table 1. The Central Bank of Lesotho (CBL) plays a predominant role and the commercial banks and that traditional bank deposits The LHWP is a four-phase project between Lesotho and the Republic of South Africa (RSA), involving the export of water from Lesotho to RSA. Phase I comprises two components Phase I A (1991-98) and Phase I B (I1999-03), with costs, respectively, of$2-6 billion and $1.1 billion. 2 Especially given that Lesotho is a landlocked country and relies heavily on South African infrastructure. represent the major forms of financial saving. Non-bank financial intermediation is relatively insignificant. Within the commercial banking sector, the Standard bank group dominates, being over twice as large as Nedbank, its only competitor. The remainder of the financial system is largely accounted for by the two development finance institutions - which do not take deposits and no longer make loans- and the insurance industry. Table 1: Structure of the Lesotho's Financial System Total Assets (M Maloti unless otherwise indicated) 1999 2000 2001 2002 Central Bank 3535 50% 3652 52% 5496 61% 4855 59% Conmnercial Banks 3046 43% 2885 41% 2908 32% 3077 37% Dev. Finance Institutions 307 4% 312 4% 325 4% 344 4% Insurance companies 216 3% 231 3% 271 3% Na Na Microfinance institutions Na Na Na Na Na Na Na Na Total 7104 100 7080 100 9000 100 8276 100 Source: CBL Quarterly Reports, SADC Statistics And Staff Estimates 5. The Central Bank-Monetary Policy. Monetary policy management in Lesotho is characterized by its historic relationship with South Africa under the terms of the Common Monetary Agreement (CMA). Under this agreement, there is an unrestricted (and unrecorded) flow of funds for both current and capital transactions within the area (encompassing Swaziland, and Namibia as well as Lesotho and South Africa). Therefore, assessing monetary developments in Lesotho is problematic given the fact that the South African Rand circulates in parallel with Lesotho's currency as legal tender within Lesotho and it is difficult to precisely determine the amount of Rand currently in circulation within the country. 6. CBL's primary monetary policy is to maintain the one-to-one fixed exchange rate between the Loti and the South African Rand by ensuring an adequate level of foreign reserves. This is achieved mainly by providing attractive domestic securities for Basotho investors and discouraging them from investing outside Lesotho and thus increasing the demand for foreign exchange. Government of Lesotho treasury bills serve as the intervention security and the CBL auctions 91-day treasury bills every month through competitive bids and 1 82-day bills every two months through a combination of competitive and non-competitive bids. Operationally, the CBL aims to control the monetary base by focusing on excess bank reserves. This is expected to influence the treasury bill rate (intermediate target) which ultimately influences whether investors keep funds inside Lesotho or transfer them abroad (foreign reserves). However, due to Lesotho's unique relationship with South Africa (RSA) and the free flow of funds between the two countries, the effectiveness of this monetary strategy depends crucially on monetary developments within South Africa. For instance, treasury bill rates in Lesotho would have to be at least comparable to, if not higher, than RSA treasury bill rates in order to encourage profit- seeking investors to hold Lesotho bills. 7. Financial sector practitioners complain that T-bills in Lesotho have paid consistently lower interest rates than those in South Africa, although these rates are now ii converging3. This would, on the surface, appear counter intuitive given the generally higher risks associated with Lesotho T-bills and the Lesotho environment. Some interviewees expressed the view that CBL's approach to the T-bill auction, in which it is a player as well as market maker in the competitive bidding for treasury bills, distorts the market and casts doubt on the extent to which T-bill rates are truly market determined. 8. Commercial banks. Lesotho has three commercial banks, Standard Bank Ltd., Lesotho Bank, and Nedbank all of which are foreign controlled. Following a partial liquidation and restructuring of Lesotho Bank in 1999, Standard Bank purchased a 70 percent share in the bank and has assumed full management control. Consequently, while Lesotho Bank's existing branch structure, client base, and investment portfolio are quite different than that of Standard Bank, the management policies and practices including interest rates and products offered are now largely identical. The Lesotho Agricultural Bank (LADB) was liquidated in September 1998. Therefore from a competition perspective, Lesotho de facto has only two banks. 9. The banking system is growing relatively slowly and over the three years (2001 to 2003), total deposits and total assets declined in real terms. Despite these declines, the banking system was quite profitable during 2002 earning a net profit of 2.6 percent on average assets and 28.4 percent on end of period equity. 10. Structurally, these three foreign owned commercial banks are sound with adequate levels of capital (a combined equity to total assets ratio of 7.2 percent as of 2002) and nonperforming loans (NPLs) comprising a reasonably low 7.1 percent of total loans. The banks are extremely liquid with 25.9 percent of total assets invested in cash and bank balances and an additional 52.3 percent invested in marketable securities, primarily T-bills in Lesotho and South Africa. 11. The report's main conclusion with respect to the banking sector is that inadequate competition is the major financial sector issue in Lesotho because of the Standard Bank Group dominance, the limited number of players, and the absence of NBFI lending institutions and other deposit taking institutions. The primary competition comes from South Africa mainly for corporate banking. 12. The banks are taking advantage of the relative lack of competition to engage in what appears to be de facto cartel-like pricing with key deposit interest rates at a negative 3 percent in real terms (2001 data), all deposit rates consistently well below those immediately across the border in South Africa, high service charges, and lending rates consistently (but justifiably) higher than in South Africa despite operating within the same common money market. 13. The report considers that the high minimum capital requirements relative to the size of the market (M1O million equivalent to USD1.25 million) for the entry of commercial bank branches and nonbank financial institutions that provide credit (e.g., leasing, hire purchase) and the absence of other differentiating requirements and enabling legislation for 3As of December 2002, CBL reported a 91 days T-bill rate of 12.19% in Lesotho compared to 12.42% in SA. Since 2003, T-Bill in Lesotho have yielded higher interest rates than T-Bills in SA. iii nonbank institutions limits the potential number of economically viable financial institutions in Lesotho because of economy of scale constraints. 14. Funds outflows to South Africa. In addition to increasing levels of Lesotho-based banking business being undertaken directly in South Africa, the commercial banking system is moving increasingly cheap Lesotho funds into South Africa for investment. The level of banking system net assets shifted abroad (the vast bulk to South Africa) increased from 11.4 percent of total assets in September 1999 to 24.5 percent as of September 2002 and it appears likely to continue to increase over the intermediate term. Non Bank Financial Institutions (NBFIs) 15. In addition to its banks, Lesotho has 4 insurance companies, 2 development finance institutions (Lesotho National Development Corporation and Basotho Enterprise Development Corporation) which no longer make loans, the recently established Standard Bank Lesotho (SBL) Unit Trust and a Corporate Bodies Pension Scheme (administered by the Lesotho National Insurance Corporation). 16. The NBFI sector is relatively underdeveloped, and, by the end of 2002, accounted for only 11 percent of total assets in the financial system (excluding CBL). Lesotho has no leasing companies, finance companies, or other financial institutions that could provide competition for the banks and provide a meaningful choice of financing alternatives beyond what may be available to them in South Africa. A major reason for this lack of institutions is the small size of Lesotho's market. However, other reasons include the lack of a coherent body of law to govern leasing transactions especially the (i) the absence of a leasing law; (ii) the absence of a pension fund enabling act; and (iii) a Financial Institutions Act that does not differentiate between banks and nonbanks. 17. As a consequence, most readers of the Act believe that any NBFI other than an insurance company must have M 10 million in initial capital and must comply with all other conditions of the Act that are set for commercial banks. As mentioned, this poses a substantial if not insurmountable barrier to entry of potential new competitors in a situation where new competition is badly needed. 18. The insurance industry. The insurance industry is poorly regulated and supervised but efforts are now being initiated to make improvements. The central bank has responsibility for its oversight and the Governor is the Commissioner of Insurance. At the time of the mission, only one insurance company had ever been inspected, the only reporting requirement was an annual report consisting primarily of the audited financial statements, and not all insurance companies had reported. Several insurance company managers interviewed by the mission appeared largely unaware of what they were required to do under the law and regulations. 19. Development Finance Institutions (DFIs). Lesotho operates with two development finance institutions, the Lesotho National Development Corporation (LNDC) and the Basotho Enterprise Development Corporation (BEDCO), which have largely ceased to operate as financial sector intermediaries. iv 20. Lesotho National Development Corporation is a government owned4 investment company which was formed in 1967 as the sole industrial and commercial development parastatal body in Lesotho. Its mandate is to initiate, promote and facilitate the development of manufacturing and processing industries, mining and commerce. At one time LNDC did substantial lending, relying on government grants and lines of credit from international financial institutions. However, loan performance was so poor that it decided to phase out term lending. LNDC is now primarily involved in promoting medium and large scale industrial investment, developing commercial real estate and industrial estates, and entrepreneur development. However, despite its past lending losses, LNDC has a strong balance sheet. While LNDC appears to have stabilized and is now profitable, it represents a huge financial investment by the Government which achieves relatively little incremental developmental impact. There is little synergy between LNDC's financial investment activities and its training programs and no advantages to Government ownership of its investment portfolio. 21. The Basotho Enterprise Development Corporation was established in 1975 and put under its own Act in 1980 as a 100% government owned parastatal to establish and develop Basotho owned small scale enterprises in the manufacturing, trading and service sectors by providing them with loans, business extension services (mainly training) and administration of industrial estates and workshops. At one time BEDCO did substantial small scale lending but repayment performance was poor and led to a phasing out of this activity. 22. BEDCO requires large subventions from Government to operate because of large losses from operations. BEDCO's future strategy with respect to whether or not it will resume microfinance lending is unclear. It's unlikely that BEDCO can develop a sustainable lending program of any type and that an effort to do so would further encourage a non-repayment culture in Lesotho. 23. The Standard Bank Lesotho Unit Trust was established in 2001 with an initial capital of M 1.5 million to manage a unit trust which presently holds roughly M 45 million in shareholder funds owned by as many as 2000 individual Lesotho investors. The unit trust is supposed to invest 30 percent of its funds in Lesotho equities, 30 percent in Lesotho treasury bills, 30 percent in other countries in the CMA, and keep about 10 percent in cash available for redemptions. The unit trust is an innovative initiative which, if well managed as it seems to be in its early stages, may make a positive capital market contribution to development and be particularly relevant in support of future privatization. 24. The corporate body pension system, which is operated by LNIC and covers only parastatals, is the only pension scheme operating in Lesotho as the few significant private schemes that exist invest most of their money in South Africa and the scheme for civil servants operates on a "pay as you go" basis. Total amount in the fund was M 54.7 million as of December 2001, down sharply from M 66.7 million one year earlier, because participating parastatals are being privatized and new owners of these companies are withdrawing from the plan. Only 9 of an original 20 participating companies continue to participate in the scheme and gross new inflows have dwindled to about M 6.6 million a 4DEG of Germany invested in a nonvoting preferred share issue in 1986. V year. The report argues that Lesotho should take more advantage of its proximity with South Africa and its developed pension industry. C. Finance for Micro Small and Medium Enterprises (MSMEs) 25. The Lesotho authorities have been mindful of the fact that the formal financial system has not provided effective support for the micro, small, and medium scale sector in Lesotho -which is almost always represented by Lesotho citizens. Consequently, the Government is revising financial support programs specifically directed at this sector, in an effort to assist their growth. In addition, several autonomous financial institutions and support organizations for the MSME sector have also been established. However, the overall impression is that there are presently no effective and well functioning programs specifically focused on providing credit to SMEs. 26. Government-Sponsored Programs. The Government, with support from donors, had been actively trying to fill the vacuum for credit services to Basotho-owned Micro, Small and Medium Enterprises (MSMEs) in the urban, peri-urban and rural areas with three programs which have achieved disappointing results: (i) the Industrial and Agro- Industries Project which disbursed about $1.1 million to refinance 12 Lesotho Bank projects but was burdened by a high percentage of non-performing loans; (ii) A Microfinance (Reconstruction Fund) Scheme developed and managed by BEDCO following the civil unrest of September 1998. Due to bad repayment performance, BEDCO has curtailed new lending under this scheme; and (iii) an IFAD-funded project, a Rural Finance and Enterprise Support Project which extended assistance for the formation of groups to enable them to save and borrow among themselves and eventually access resources from banks. 27. CBL new programs: CBL is revising three guarantee programs that are still on the drawing board to increase the level of lending provided by the commercial banks to small and medium scale businesses and exporters, including: (a) the Export Finance and Insurance Scheme; (b) the Rural Savings and Credit Program (which aims to further the objectives of the completed IFAD-funded Rural Finance and Enterprise Support Project); and (iii) a Development Finance Project targeted at SMEs. 28. Under these programs, participating banks can apply for guarantee coverage on loans they extend to qualifying businesses under certain terms and conditions relating to maximum loan size, loan term, interest rates, and loan purpose. While there is a role for these CBL administered guaranteed programs over the intermediate term in view of the virtual absence of effective MFI programs and highly conservative commercial bank lending strategies, the performance under the new schemes may not be different from that of the schemes they were designed to replace without fundamental changes to its design in light of the relatively poor response from the commercial banking sector in the old scheme. 29. It is recommended that, for all of these programs, the interest cap be removed as it could be a significant disincentive for the commercial banks in this high credit risk environment and is likely to dampen their enthusiasm for the program. vi 30. The Postal Financial Services. Currently, the Government is considering the re- establishment of financial services for the public throughout the country to be provided by the Post Office. It is envisaged that the Lesotho Postbank (LPB) would provide a full package of retail banking services over time. The LPB would be developed in phases with services to be introduced in 10 pilot areas and technical and/or management to be provided through a partnership between the Government and a strategic partner. 31. Risks associated with the proposed LBP are high and achieving viability would be difficult even if its objectives were primarily commercial. Most postal banks in Africa have serious operational and control problems and have performed poorly financially. It is, therefore, recommended that the LBP not be reestablished unless i) all control problems relating to accounting for deposits are solved; (ii) it operates only in locations for which anticipated volume of business will allow breakeven financial performance within a period of two years; (iii) and it is not allowed to make loans. 32. Deposits could be used to invest in CBL guarantee schemes, T-bills, and longer- term bank deposits. Also, if this project does go ahead, it is recommended that the Postal bank not be re-established before the private shareholders and the technical partner have been identified, a comprehensive business plan and modus operandi have been developed, and the overall implementation arrangements agreed upon. 33. Cooperatives and Credit Unions. Reports on the performance of cooperatives and credit unions suggest that some are collapsing or on the verge of collapsing while others continue to operate despite serious weaknesses. 34. Unverifiable information indicated that there were about 83 credit unions in Lesotho in 1991 and 131 in 2002. While there are also over 1,000 cooperatives which provide financial services, verifiable information from the Commission of Cooperatives was not available as to the number of cooperatives established primarily as savings and credit cooperatives. Credit's experiences of cooperatives are said to be comparatively better than other institutions because of group discipline, peer pressure and shared interest within the cooperatives. 35. Money Lenders. There are about 25 money lenders registered with CBL, of which 10 meet CBL reporting requirements. They generally lend out small amounts to civil servants, employees of government agencies, and construction contractors. CBL regulates money lenders and has imposed on them a maximum lending rate of 25 percent per annum which, if they comply, significantly reduces the amount of lending they undertake. 36. It appears unlikely that the benefits associated with CBL supervision of money lenders exceed the disadvantages as money lenders do not take deposits from the public. It is recommended that the decision as to whether or not CBL should supervise money lenders should be reviewed. F. Enabling Environment for Financial Sector Development 37. The legal framework is seen to be a deterrent to financial intermediation and increased access to credit in Lesotho as it fails to guarantee property rights as an instrument vii that can be used for collateral and does not support property rights enforcement. Married women are legally disadvantaged in their treatment within the banking system, as in Lesotho matrimonial law treats women as minors. Unable to be sued in a court of law (as a legal minor), women cannot undertake many financial activities without the consent of their husbands -including opening a new account, taking out a loan, registering immovable property in their name, acting as a company director or binding themselves as surety.5 Although the application of this discriminatory practice is seemingly not uniform, it nonetheless places impediments on the development of an important group of entrepreneurs in Lesotho's society. 38. Enforcement of legislation is also constrained by slow execution of due process manifested by slow court proceedings and lenders' inadequate access to timely foreclosure procedures. The execution of court orders, even after considerable delays, is rarely undertaken in a timely manner. The Commercial Court, which has been established at CBL's initiative in 2000, has had little or no impact at all on the adjudication of commercial cases. This is largely attributable to resistance shown by legal practitioners to the new procedures and ignorance on the part of stakeholders such as business community, judges and legal practitioners. 39. The absence of adequate credit assessment information tools has also been a contributing factor. There is no credit bureau in Lesotho. CBL is considering setting up a credit bureau in collaboration with the commercial banks. However, the absence of a unique personal identification system represents an important constraint. G. Priorities for Reform 40. This report has listed many recommendations for reform in the financial sector which are listed in their entirety in Annexl. The following issues and recommendations to address them are the priority reforms needed to enable the financial sector to provide better support for private sector led growth and Lesotho's poverty reduction strategy. 41. Competition in the banking system. To enhance competition in the financial sector from the lending and deposit collection sides the report recommends that proposed amendments to the Financial Institutions Act 1999 be drafted to allow for the licensing of nonbank financial institutions and bank branches under conditions that differ as appropriate from those pertaining to banks including significantly lower minimum capital requirements. However, institutions with an "NBFI or Tier Two" license should not be allowed to take demand deposits and other specified deposits from the general public as they are likely to be riskier than full commercial banks and to ensure an equal playing field among demand deposit takers. 42. Leasing. The government should pursue the establishment and development of a leasing industry by (i) the promulgation of a Leasing Act consistent with if not identical to the corresponding Act in South Africa, which will indicate the rights, duties and obligations of participants including those related to the adjudication of cases; and (ii) 5The "Married Persons Equality Rights" written by the Law Reform Conmnission in 2002 is still under review viii attempt to attract investors with experience in leasing to set up operations in Lesotho and diversification of the sources of leasing finance by tapping insurance firms and pension funds. 43. Contractual Savings Institutions. The Government and CBL should strengthen regulation and supervision of this subsector by (i) commissioning a study of Lesotho's pension industry and the related laws and regulations; and (ii) following up on the FIRST study to strengthen insurance industry regulations and reporting and develop effective off- site supervision based on that reporting. It is recommended that pensions and insurance laws and regulations should be harmonized with those in South Africa. Lesotho should consider allowing reputable South African pension managers, who are under effective supervision in South Africa, to operate within Lesotho subject only to an additional constraint that some portion of the funds mobilized in Lesotho be invested there. Given serious economy of scale constraints, CBL should also consider subcontracting responsibility for supervising its insurance companies to the South African supervising authority. 44. Development Finance Institutions (DFIs). It is recommended that no new lending be undertaken by either LNDC or BEDCO. LNDC's equity and real estate investment portfolios should be spun off from its entrepreneur development and training activities in the form of a new company which should be privatized. A BEDCO corporate strategy study should be undertaken to i) examine the feasibility of merging BEDCO with LNDC's noninvestment activities and making it the single focal point for training and promotion support for both small and larger scale industry; ii) eliminating BEDCO's lending function and recommending a collection and disposition strategy for dealing with the largely moribund BEDCO and LNDC loan portfolios; and iii) preparing a corporate strategy and business plan for BEDCO's ongoing operations. 45. Finance Micro, Small and Medium Size Enterprises (MSMEs). It is recommended that Government create a better enabling environment by developing a Rural and Microfinance Policy and Development Action Strategy within the framework of the ongoing PRSP which will include, inter alia, (i) a careful assessment of the different kinds of existing microfinance institutions (MFIs) and the nature of their activities, scale and funding sources as the basis for (ii) the definition of a regulatory and supervisory framework for MFIs guided by whether and how to supervise and regulate them; and (iii) the creation of a rural and microfinance forum or association to serve as a body that will set standards for rural and microfinance services and provide a platform for discussion and information dissemination. 46. Legal and judicial study/reforms. The legal and judicial environment in Lesotho should be studied to design reforms necessary to significantly improve the credit disciplinary environment. In particular, the recommendations should aim at (i) taking steps necessary to remove all obstacles to effective functioning of the commercial courts including streamlining procedures for registering "bonds" or claims against collateral and providing technical assistance to practitioners on financial sector operations; (ii) ensuring that a credit information bureau is functioning effectively; (iii) ensuring that the old bad loans of Lesotho Bank and the Agricultural Bank are collected in all cases except where Ix borrowers have no capacity to pay; and (iv) reforming the clauses in the Matrimonial Act that do not allow married women to borrow without their husband's signature. 47. Dialogue with authorities. CBL officials and the PRSP committee have expressed support for ongoing financial sector reform and interest in ongoing Bank support for structuring and implementing needed reforms. There is a need for the Bank to closely monitor developments in the financial sector through regular dialogue with the Lesotho's authorities. This proactive stance will enable us to assist the Authorities in addressing issues and challenges as they arise. x CHAPTER ONE MACRO-FINANCIAL FRAMEWORK AND STRUCTURE OF THE FINANCIAL SYSTEM A. MACROECONOMIC OVERVIEW 1. Lesotho is a poor landlocked country completely surrounded by and therefore dependent on the Republic of South Africa (RSA). With a population of nearly two million people, eighty percent of which live in rural areas, Lesotho's GNP per capita stood at $540 in 2000. Lesotho's economy is based on limited agricultural and pastoral production, light manufacturing (clothing, textile, and leather), and remittances from Lesotho mineworkers in South Africa and more recently, receipts of royalties for supply of water to Republic of South Africa (RSA) under the Lesotho Highland Water Project6. Lesotho is a member of the Southem African Customs Union (SACU) and the Common Monetary Area (CMA), sharing the customs receipts collected by SACU. Its currency is pegged at par to the RSA Rand, limiting its monetary policy as means to promote economic growth and development. 2. Until the late 1990s, economic performance in Lesotho was favorable. Political uncertainty in South Africa until the early 1990 led to an increase in corporate investment in Lesotho, much of it as a result of efforts to circumvent sanctions. Construction of Phase IA of the Lesotho Highlands Water Project (LHWP) and rapid expansion of manufacturing production and exports propelled economic activity, and real GDP growth averaged over 6 percent per annum in the decade ending in 1997. Monetary and economic integration with South Africa resulted in relatively low inflation, and prudent fiscal management led to the accumulation of sizeable government deposits in the banking system and a comfortable net intemational reserve position. A positive development has been the surge in foreign direct investment in manufacturing in the past decade to take advantage of regional trade arrangements and more recently the United States African Growth and Opportunities Act (AGOA) which has boosted employment and export revenue. 3. But economic performance began to deteriorate in the late 1990s with the winding down of activity in Phase IA of the LHWP, the attainment of close to full production capacity in the manufacturing sector, and a reduction in miners' remittances from abroad. The political disturbances of September 1998, which resulted from discontent with the results of the 1998 general elections and led to the intervention of Southern African Development Community (SADC) troops, also adversely affected economic activity. As a result, real GDP declined by almost 4 percent in fiscal year 1998/1999. Inflation remains moderate, falling to 8.9 percent in 2000 but increased to around 11 percent in 2002. Economic growth is expected to remain lower in the medium term compared to the past decade, for two reasons. First, Phase lB of the LHWP, which started in 1998 and runs through 2005, is much smaller than Phase 1A and its economic impact will be correspondingly lower. Second, continued rationalization of mining production methods in South Africa dims the prospects for mining employment for Lesotho workers. 6 The LHWP is a four-phase project between Lesotho and the Republic of South Africa (RSA), involving the export of water from Lesotho to RSA. Phase I comprises two components Phase IA (1991-98) and Phase I B (1999-03), with costs of $2.6 billion and $1.1 billion I 4. The current macroeconomic environment in Lesotho reveals a mixed picture, with satisfactory performance on some indicators tempered by unfavorable trends in others. Following the sharp fall in domestic output in 1998 when political disturbances led to a 4.6% fall in GDP (Table 2), production has since recovered somehow but yet slow, with an average GDP growth of 3.45% over 1999-20027. Table 2: Selected Macroeconomic Indicators (1996-2002) 1996 197 l998 199 2000 2001 2001 Fe GDPgmth (O, 10 8.1 -4.6 22 3.8 4 a8 ilnfm rate(D4(Q1)(1997=1l0t 9.1 85 7.8 a6 6.1 6.9 a8 Ovfislainli m glg -0.2B -1.6 -4.5 -155 -7.5 -3.4 -8.7 Dxiic Rtiic RDbt (/ocdGNf 3 25 10.3 10.4 9 na CGM t1rsic Svirp (%cdGEF) -29.9 -24.5 -27.1 -24.1 -20.2 -14.8 -5.8 Q li S (°/6 d G F) 25S4 268 16.5 21.3 23.4 23.8 21.8 Cks Dxxt ic Jne(%mit (%cfdGE) 58.4 54 47.1 4a3 39.5 36.8 36.2 1 urcee (a'/oC [fCM -33 -27.2 -30.6 -22 -16.1 -13 -14.4 COTat axwt bxilarne (r/ocfGt -33a8 -31.2 -285 -24.3 -19.3 -1.22 -11.8 Eqxat fgxods and smdces (aR" %gmdk 23.3 182 -9.7 ll -67 40.4 4.2 antikrmal1 wsE m fshnsdizxgits 52 58 67 64 S8 63 S6 hkslat xdla(L/V 4.3 4.6 55 6.1 6.9 86 1Q5 Etfinal Debt ($nhi1ia 701.2 673.5 6882 6821 671.4 5925 na &wut Onbd Bx*ofLesf k&ilatkd Amcd &tMscs ad WlidB* adgi?t kxrns 5. This recovery in output has been mainly driven by a combination of a buoyant construction sector (a direct fall-out of the government's reconstruction and rehabilitation program), and the robust recovery in manufactured exports, especially textiles which contributes over 70% of Lesotho's total exports. A pick-up in retail trade has also contributed. 6. As at end-2002, inflation stood at about 11%, up from the 8.6% recorded in 1999. With over 90% of Lesotho's imports coming from South Africa, inflation is primarily driven by prevailing prices in South Africa although movements in the exchange rate vis-a- vis the dollar have also been a major factor influencing price developments. 7. Government finances have however been a problem area withfiscal deficits in 1999 amounting to a substantial 15.5% of GDP, due mainly to a sharp fall in grants. The costs associated with the restructuring of Lesotho Bank and the liquidation of the Lesotho Agricultural Development Bank (LADB) also contributed to the large size of fiscal deficits. Although deficits had declined to 3.4% of GDP by 2001, a combination of increasing government spending on famine relief and delays in the disbursement of donor funding is expected to result in 2002 deficits amounting to 8.7% of GDP. 8. Reflecting the growth in fiscal deficits, the stock of domestic governnent debt rose rapidly from Ml 90.2 million in 1997 (3% of GDP) to M763.3 million by end-2001 (9% of GNP) [table 3]. 7 GNP has however grown at a slower pace due to a sharp fall in net factor income from abroad following the retrenchment of Basotho migrant mineworkers in South Africa 2 Table 3: Financing Domestic Government Debt 1996 1997 1998 1999 2000 2001 Total D[nstic Debt (Mlhmon Malofa) 303.3 190.2 160.1 730.2 810.0 763.3 Dorstic debt/GNP (0/4 5.5 3.0 2.5 10.3 10.4 9 Holders of Dmlrstic Public Debt (%of Total) Banks 783 568 35.1 81.0 74.5 86.7 A\on-banks 21.6 43.1 64.8 19.1 25.4 13.2 Source: Central Bank of Lesotho 9. A breakdown of domestic government debt by holder reveals that banks have been the principal financiers of government spending. In 2001, the banking system held 87.6% of total domestic debt and banking system holdings averaged 81% of total debt over 1999- 2001. 10. This situation, combined with high levels of bank investment in RSA, suggests that there may be substantial crowding-out of the private sector in the allocation of resources. In 2001, banking system holdings of government debt represented 22.8% of total bank assets and 70.4% of total banking credit to the private sector. In contrast, the proportion of government debt held by the non-bank public has declined progressively to stand at only 13% in 2001, compared to a high of 64% attained in 1998. 11. Lesotho has also been experiencing a high degree of pressure on its external position, with substantial current account deficits averaging 17% of GDP over 1999-2002. The current account picture is however improving due to the preferential trade status accorded Lesotho under the African Growth and Opportunity Act (AGOA) and the subsequent increase in the volume and value of exports. The size of the current account deficit has consequently shrunk from 19.3% of GDP in 2000 to stand at 11.8% of GDP as at end-2002. 12. In spite of pressures on the external account, foreign exchange reserves remain at reasonable levels, standing at 5.6 months of imports in 2002 and averaging 6 months of imports over 1999-2002. By virtue of its membership of the Common Monetary Area (CMA), the domestic currency, the Loti, is pegged one-for-one to the South African Rand. Against the US Dollar, it has however been depreciating over the past few years, standing at 10.5 Loti to a dollar in 2002 compared to 4.3 Loti per dollar in 1996 (a depreciation of roughly 60%). This depreciation in the domestic currency is one of the key factors behind the recent increase in exports from Lesotho as her manufactures became more competitive in terms of price. B. MONETARY AND CREDIT DEVELOPMENTS 13. Assessing monetary developments in Lesotho is problematic given the fact that the South African Rand circulates as legal tender within Lesotho (as a member of the CMA) and it is difficult to precisely determine the amount of Rand currently in circulation within the country. However, focusing on the Maloti component of the money supply as an indicator of broad money (M2) trends, M2 growth in Lesotho has been erratic, going from a 15.5% expansion in 1998 to a 5% decline in 1999 (Table 4). A low 1.4% growth in 2000 was followed by a 17.2% expansion in 2001. This observed pattern in the growth of broad money has been largely driven by changes in both net foreign assets and domestic credit. Trends in narrow money (Ml) have been similar over the same period. 3 Table 4: Monetary Developments, 1996-2001 (excluding Rand in circulation) 1996 1997 1998 1999 2000 2001 Money supply (M2)(M million) 1334 1531 1768.8 1677.8 1700.9 1992.7 Demand and call deposits 551.6 691.2 843.1 829.2 881.4 949.8 Savings deposits 472.3 519.7 573.4 527.5 506.4 521.8 Time deposits 220.1 224.3 212.2 193 158.5 178.6 Currency 84.1 92.5 134.5 122.7 139.3 147.1 Growth of M2 14.7 15.5 -5.1 1.3 17.2 Memorandum items Demand and call deposits (%of total) 41.3 45.1 47.7 49.4 51.8 47.7 Savings deposits (% of total) 35.4 33.9 32.4 31.4 29.8 26.2 Time deposits (% of total) 16.5 14.7 12.0 11.5 9.3 9.0 Currency (% of total) 6.3 6.0 7.6 7.3 8.2 7.4 Source: Central Bank of Lesotho 14. Net claims on government have been growing rapidly but are negative as government deposits with the banking system are substantial, resulting in negative numbers for net credit to the government. Net claims on the government grew from M-985.5 million in 1999 to stand at M-628.1 million as at end 2002 (Table 5). In growth terms, net claims on government expanded by -14.4% in 2001 compared to -25.6% in 1999. Despite these trends, bank loans to government amount to only 6.2% of total loans although bank holdings of govermment securities are substantial. 15. Growth of credit to the private sector has fallen sharply from 33% in 1997 to only 6.6% in 2001. A decline of 6% was recorded for 1998 due to the civil unrests of that year. Although credit to the private credit has slowed down considerably, in absolute terms, it recorded an increase from M 899 million in 1997 to M 941 million in 2001. Overall, net loans and advances from the banking system constitute a low 17.6% of deposits and gross 8 loans represent a very low 5 percent of GDP as of December 2002 . Credit to the private sector of M359 million represents only 4% of GNP and grew at 6.6% (a real negative rate) during 2001. 8 For details see chapter two on the banking system 4 Table 5: Domestic Credit Developments, 1996-2001 1996 1997 1998 1999 2000 2001 Total Domestic credit (M million) -503.3 -844.5 -944.4 -22.7 228.6 359.3 Domestic Credit to Private Sector (M million) 676 898.8 841.2 857.5 883 941 Domestic credit to govemment (net)(M million) -1321 -1870.9 -2011 -985.5 -733.6 -628.1 Domestic credit to statutory bodies(M million) 141.3 127.6 225.5 105.3 79.2 46.4 Memorandum items Growth of private sector credit (%) 33 -6.4 1.9 3.0 6.6 Growth of govemment credit (%) 41.7 7.5 -51 -25.6 -14.4 Growth of credit to statutory bodies (%) -9.7 76.7 -53.3 -24.8 -41.4 Domestic Credit to Private Sector (% of GDP) 24 22 17 16 15 Domestic credit to government (net)(% of GDP) Domestic credit to statutory bodies(% of GDP) Source: Central Bank of Lesotho C. STRUCTURE OF INTEREST RATES 16. Nominal prime lending rates in Lesotho have shown a downward trend, currently standing at 16.3%, compared to a high of 22% recorded in 1998 (Table 6). Rates on savings deposits have also been trending downwards although Lesotho banks have historically paid much smaller returns on savings deposits. While lending rates have remained positive in real terms, real savings rates turned negative in 1999 (-1.1%) and in 2001, real savings rates were negative by as much as -2.9%. This is a reflection of the lack of competition in the banking sector for retail deposits and becomes more worrying given the fact that interest rates on deposits in South African banks are almost double what is paid for deposits in Lesotho. Such levels of negative real yields constituted a major disincentive to financial savings and increasing amounts of Basotho savings are beginning to flow into accounts in South African banks across the border. This is an undesirable loss of scarce resources for a country like Lesotho which urgently needs to mobilize a greater amount of domestic resources for productive investment. 17. In addition, the spread between saving and loan rates has grown over the years, amounting to 12.3 percentage points in 2001, substantially up from the 5.3 percentage points recorded in 1997. Such wide spreads discourage domestic resource mobilization as domestic savers perceive returns as too low and subsequently seek alternative saving vehicles, usually in South Africa. Also, potential borrowers also view lending rates as too high relative to expected returns and are also discouraged from borrowing for productive investment. Consequently, the economy experiences low domestic saving and investment, with attendant adverse consequences for growth and development. 18. Spreads on lending are not far out of line with those in other Sub-Saharan countries, largely justified given the poor credit disciplinary environment characterized by historic high default combined with a legal and judicial environment that provides poor support for lenders, and unlikely to narrow significantly before these underlying factors are addressed. However, the overall spreads are remarkably high given that the banks invest most of their resources in extremely safe government debt instruments and bank deposits. This, together with the observation that, although lending rates have been declining gradually, savings rates paid on deposits have fallen faster provide additional evidence of the lack of competition in the banking system, especially on the retail side. 5 Table 6: Selected Interest Rates (%) 1996 1997 1998 1999 2000 2001 Central Bank call rate 15 13.17 15.99 8.88 7.88 7.88 Central bank 31 day rate 15.25 13.5 16.25 9.33 15 13 Treasury bill rates 14.3 14 16.6 9.9 9.97 11.79 Commercial bank rates Savings deposit rates 12.7 11.8 10.7 7.5 4.9 4 Prime lending rate 18 17.1 22 18 17 16.33 Real treasury bill rate 5.2 5.5 8.8 1.3 3.87 4.89 Real prime lending rate 8.9 8.6 14.2 9.4 10.9 9.43 Real savings deposit rate 3.6 3.3 2.9 -1.1 -1.2 -2.9 Interest rate spread 5.3 5.3 11.3 10.5 12.1 12.33 Memorandum items South African interest rates Call deposits 18.5 15.3 20.2 10.8 9.75 8.85 Prine lending rates 20.25 19.25 19.34 15.5 14.5 13 Source: Central Bank of Lesotho D. SAVINGS AND INVESTMENT 19. Gross domestic savings in Lesotho are negative, averaging -16.2% of GDP over 1999-2002 (Table 2). This is a reflection of Lesotho's substantial migrant labor population and a look at gross national savings (GNS) paints a different picture. GNS stood at 22% of GDP in 2002, averaging 22.5% of GDP over 1999-2002 (One of the largest user of domestic savings, compared to other African countries). Although the level of domestic investment has fallen from a high of 58.4% of GDP in 1996 to stand at only 36.2% of GDP in 2002, available national savings have not been sufficient to cover domestic investment, with the resultant resource imbalance standing at 14.4% of GDP in 2002 (16.4% average over 1999-2002). The low level of savings is a direct reflection of the low levels of income and the increasing levels of poverty incidence in Lesotho. The increasing levels of fiscal deficits and the associated depletion of public sector savings have also reduced total domestic savings. Also, the current level of domestic investment (36.2% of GDP) is well below the estimated 45% of GDP considered necessary to maintain a GDP growth rate of 5% per annum, the estimated growth rate required to make a significant dent in poverty. E. FINANCIAL DEEPENING 20. Financial depth in Lesotho as measured by the ratio of broad money (M2) to GDP stood at 27.1% in 2000, slightly above the 25% average for Sub-Saharan Africa as a whole (Table 7). By Sub-Saharan African standards, Lesotho also shows relatively low level of currency as a proportion of broad money (Table 4) which averaged 7.1% over 1996-2001. These ratios are substantially understated as an uncounted (it's unquantifiable) but substantial amount of RSA rand is also circulating in Lesotho. 6 Table 7: Indicators of Financial Depth 1997 1998 1999 2000 2001 M2/GDP(%) 32 36 30 28 31 Deposits/GDP (%) 75.0 78.0 58.0 50.0 55 Source: Central Bank of Lesotho 21. This significant financial depth is quite surprising given the small size of the Lesotho economy, the financial system, the relatively low negative in real terms level of deposit interest rates and the undercounting of RSA Rand circulating in the system. It should however be noted that the level of broad money is substantially influenced by the inflow of a portion of miners' wages into the Miners Deferred Pay Fund (MDPF), which is counted as part of M29. 22. A look at bank deposits paint a different picture and perhaps reflects the relatively low levels of deposit rates. The ratio of bank deposits to GDP has fallen steadily from a high of 78% of GDP in 1998 to 55% in 2001. Although these numbers indicate a progressive financial disintermediation, they are still high when compared to the sub- Saharan African average. F. MONETARY POLICY AND THE FINANCIAL SYSTEM 23. Until September 2001, CBL relied on direct techniques of monetary control, including credit ceilings and interest rate controls. At that time CBL adopted indirect techniques of monetary control on the grounds that banks circumvented direct controls and such controls were causing distortions in resource allocation. The CBL thus introduced open-market type operations which were expected to be more effective in managing liquidity and increase the flexibility of monetary policyl'. Monetary policy is now conducted principally through the monthly sale and purchase of treasury bills. 24. The primary objective of monetary policy is to maintain the one-to-one fixed exchange rate between the Loti and the South African Rand by ensuring an adequate level of foreign reserves. This is achieved mainly by providing attractive domestic securities for Basotho investors and discouraging them from investing outside Lesotho and thus increasing the demand for foreign exchange. Government of Lesotho treasury bills serve as the intervention security and the CBL auctions 91-day treasury bills every month through competitive bids and 182-day bills every two months through a combination of competitive and non-competitive bids". The amounts on offer at the auction sessions are determined based on CBL's evaluation of the level of excess liquidity in the system. The auction technique is multiple-price, whereby t-bills are allocated starting with the most competitive bids until the entire issue is exhausted. The lowest accepted rate then becomes the cut-off rate. This approach allows bidders to express their demand for t-bills through their bidding strategies. 9The MDPF is held in bank accounts in Lesotho and miners can access them upon return to Lesotho. 10 Open market-type operations differ from full open market operations in that they involve central bank operations in the primary market for treasury bills through auctions rather than direct involvement in the open secondary market. l Non-competitive bids are reserved for small investors. 7 25. Operationally, the CBL aims to control the monetary base by focusing on excess bank reserves. This is expected to influence the treasury bill rate (intermediate target) which ultimately influences whether investors keep funds inside Lesotho or transfer them abroad (foreign reserves). However, due to the unique relationship of Lesotho with South Africa and the flow of funds between the two countries, the effectiveness of this monetary strategy depends crucially on monetary developments within South Africa. For instance, treasury bill rates in Lesotho would have to be comparable to RSA treasury bill rates in order to encourage investors to hold Lesotho bills. Available data indicate that Lesotho t- bill rates have more or less converged on RSA t-bill rates (91-day bills) but the transmission of t-bill rates to other rates in the financial system is rigid. Further, it is difficult for the CBL to exert full control over money supply given the free circulation of the Rand within Lesotho and the lack of precise data on the amount of Rand in circulation. In effect, monetary policy in Lesotho is only able to control the Loti component of the money supply. Figure 1: T-bill Rates in Lesotho and South Africa (1997-2002) 14 12 -4- Ls Av. Yield T-bills 6 ll-= Sa. Av. yield T- bills 2 1999 2000 2001 2002 year Source: CBL 26. Deposit interest rates have however remained low and spreads high despite recent increases in t-bill rates. In July 2002, the CBL introduced a Lombard window through which it could extend short-term liquidity facilities to banks. 27. Due to underdeveloped state of financial markets in Lesotho, the CBL still maintains cash and liquidity requirements which serve as ancillary tools of monetary control in pursuing its objective of maintaining an adequate level of foreign reserves. 28. The effectiveness of indirect monetary instruments will depend on the development of money markets and their ability to transmit CBL policy changes to other segments of the financial system. CBL is well aware of this and has recently taken steps to improve the operations of money markets, including the payment system, introducing a legal framework for settlement procedures and reducing the settlement period for transactions. Efforts to make the inter-bank market more active are also in the right direction. However, at present 8 the structure of the financial system indicates that there is poor transmission of monetary policy as interest rates (especially deposit rates) do not appear to respond to changes in monetary policy. G. FINANCIAL POLICIES 29. Reserve requirements. Banks in Lesotho are required to maintain cash reserve balances of 3% of total liabilities in the form of non-interest bearing deposits with the CBL. In addition, they are also required to maintain liquid assets of not less than 25% of total liabilities, with the following assets declared as eligible for meeting liquid asset requirements: i) deposit balances with the CBL (excluding cash reserve balances); ii) balances due from banks in Lesotho; and iii) treasury bills and other securities issued by the CBL or the government with remaining maturities of 370 days or less. There is a one week reserve maintenance period and banks are allowed to offset any deficiency in daily liquidity positions against excess liquidity in any other days within the reporting week. 30. Liquid asset requirements (LAR). The 25 percent liquid asset requirement can be met with deposits in the central bank, cash in vaults, government securities or balance due from other banks in Lesotho. These assets are all domestic and therefore can be seen as a de facto minimum local asset requirement (although it is not a requirement to hold productive local assets). The initial policy in the form of a requirement for commercial banks to hold a minimum amount of local assets was originally introduced in 1981 in an attempt to limit the outflow of funds to RSA and ensure that a specified proportion of resources mobilized within Lesotho remained available for domestic investment. In line with the ongoing reform of financial policies, the prescribed ratio has been lowered from the initial 85% in 1981 to 60% in 1998, to 40% in 2000 before being eliminated in September 2001. It is estimated that roughly 25% of deposits mobilized within Lesotho finds its way into South African banks. 31. Lesotho's banks have found a loophole that enables them to significantly reduce the impact of the LAR by lending each other large amounts of money. Therefore, it is recommended that the LAR be redefined to exclude balances lent to local commercial banks. 32. Credit policies. The CBL's Rural Finance Division (RFD) which is attached to the Supervision Department plays an important role in the formulation of savings and credit policies to govern rural finance. The RFD has developed the Broad National Rural Savings and Agricultural Credit Policy (BNRSCAP) which was aimed at facilitating the implementation of the Rural Finance and Enterprise Support Project (RFESP). The policy framework does not appear to interfere with market forces in the determination of interest rates and directions of lending. It has mainly focused on creating an enabling environment for more robust operations of rural financial institutions (especially rotating savings and credit groups) and forging linkages between rural finance institutions and commercial banks. It is the mission's view that the CBL should continue to limit its role to that of enabler or facilitator and avoid direct involvement in the determination of interest rates or the direction of credit. 33. CBL is in the process of redesigning several credit guarantee programs it has been administering for some time. This is not normally an appropriate activity for a central bank to engage in because it diverts attention from more important functions and can create a 9 conflict of interest versus its bank supervision responsibilities. However, the mission recommends that CBL continues with these operations over the intermediate term given the virtual absence of MFI lending institutions and programs and highly conservative bank lending strategies providing they are appropriately redesigned. It is imperative that all interest rate limitations be removed from these programs to increase the incentives for participating banks to utilize the facilities and to ensure that they do not undermine the development of unguaranteed MFI initiatives which would need to lend at substantially higher interest rates than the present caps in these programs to have any chance to operate on a financially viable basis. 34. Ownership of financial institutions. With the liquidation of the Lesotho Agricultural Development Bank (LADB) and the sale of 70% of government shares in Lesotho Bank to Standard Bank, the Lesotho banking system is now predominantly foreign-owned12. However, the Lesotho National Insurance Group (LNIG) is still 50% government-owned with the rest held by two foreign insurance companies. The Lesotho National Development Corporation (LNDC) and the Basotho Enterprise Development Corporation (BEDCO) are respectively 60 percent and 100 percent government owned. 35. Entry policy. The authorities maintain an open policy with regards to entry into the financial system. However, current entry requirements are applied to both banks and non- bank financial institutions (NBFIs), a situation which has discouraged the emergence of NBFIs and continue to limit the degree of competition in the financial system. A minimum of M1O million ($US1.25 million) is required to license banks, a sum which is obviously too high for NBFIs such as finance and leasing companies. 36. In an attempt to further increase the degree of competition in the financial system, the mission was informed that CBL is considering licensing foreign banks to open branches in Lesotho. While this has the potential to introduce more competition, such a move should be carefully studied in terms of its impact on existing financial institutions and the implications for maintaining a level playing field in the financial system before taking a decision as to whether or not to implement it. The two existing South African banks, which need to fund all of the overhead associated with a de jure company, would be at a substantial disadvantage in competing with a South African competitor which could avoid those costs by operating as a branch, thus creating a highy unfair playing field that could conceivably lead to the exit or one of the present players from the market. 37. Interest rates. In 1998, as part of wider financial sector reforms, the CBL abandoned its policy of fixing minimum deposit rates and controlling lending rates. Presently, both deposit and loan rates are market determined in Lesotho. However, like most other monetary variables, interest rates in Lesotho are heavily influenced by those in RSA. 38. Exchange rate and exchange controls. As a member of the Common Monetary Area (CMA), the Lesotho Loti is pegged to the RSA Rand. There are no restrictions on payments and transfers for current international transactions. The CMA has it origins in the Rand Monetary Agreement. The agreement within the region and subsequent changes which culminated in the 1986 CMA for the monetary arrangement recognized the 12 The govermment has since sold half of its remaining shares to the Lesotho Unit Trust, part of the Standard Bank Group. 10 leadership of RAS in monetary management but provided more independent monetary arrangement and some discretion in monetary and foreign exchange management for smaller countries. As a result, the CBL is responsible for managing the gold and foreign reserves for Lesotho and 35 percent of its gold and foreign exchange reserves in currencies other that the Rand. A further amendment of the CMA agreement in 1988 includes two more changes. First, in the context of Lesotho, it implies that the 35 percent non Rand limitation on currency composition of foreign reserves was eliminated. Secondly, the total amount of Loti issued by the CBL can now be backed by other convertible foreign currencies instead of just the Rand. However, two fundamental constraints remain, i.e., Lesotho has no control over its exchange rate as the Loti is pegged to the Rand and CBL cannot make any fiduciary issue (issue of currency not backed by gold or foreign exchange reserves). 39. Central bank autonomy. The Central Bank Act 2 of 2000, which replaced the Central Bank Act 13 of 1978 (as amended), is significant as it invests CBL with a high degree of autonomy in discharging its responsibilities. Price stability is stipulated as the primary CBL objective in order to clarify its mission and prevent its undertaking of numerous and often conflicting activities. Also, appointing and removing the Governor and Deputy Governors is largely insulated from short-term political influences as the new Act stipulates that they can only be removed for objective reasons such as breach of qualifications, misconduct or unsatisfactory performance. In addition, the Minister of Finance is no longer required to approve the appointment of CBL staff. This allows the CBL (at least on paper) more operational freedom as an institution in pursuing its objectives. Perhaps most important, the CBL is prohibited from engaging in quasi-fiscal activities which maintains the essential distinction between monetary and fiscal policy and contributes to its pursuit of price and monetary stability. In order to ensure the accountability of CBL, there are provisions for periodic reporting to the Finance Minister and to Parliament and for timely publication of audited CBL accounts. H. RELATIONSHIPS WITH SOUTH AFRICA 40. Given the limited scope of this study, the mission did not examine several broader issues that relate to Lesotho's relationship to South Africa's financial sector and the Common Monetary Area which would require a study of other countries in SSA as well as Lesotho; i.e., i) whether or not Lesotho should continue to maintain its currency separate from the South African Rand; and ii) whether or not the Central Bank of Lesotho should subcontract some supervision functions to South African supervisory entities because of economy of scale considerations. 41. However, it must be recognized that a combination of Lesotho's membership in the CMA and the South Africa Customs Union (SACU), plus the fact that it is completely surrounded by South Africa has resulted in a unique relationship between the two countries. The small size of Lesotho relative to RSA (both geographically and economically) makes it especially sensitive to developments in its larger "neighbor". Lesotho's GDP is less than 1% of RSA's GDP, 90% of its imports come from RSA, and RSA receives 50% of Lesotho exports. In addition, it is estimated that over 10% of Lesotho's male population work in RSA mines and remittances constituted the principal source of foreign exchange until 2001 when eamings from textile exports exceeded remittances. As many of these workers are retrenched from South African mines, the implications for the financial system in terms of savings mobilization (MDPF) and access 11 to foreign exchange are significant although the recent expansion of textile exports is expected to somewhat mitigate the foreign exchange impact. 42. The free flow of funds between both countries has important implications for the financial system in Lesotho. In the first place, it implies that interest rates in Lesotho cannot be out of line with rates prevailing in RSA, otherwise funds will flow into South Africa. Available evidence indicates that this is the case due to the relatively low levels of deposit rates in Lesotho and anecdotal evidence suggests that roughly 25% of deposits mobilized within Lesotho ends up in South Africa. In addition, implementing monetary policy in Lesotho is complicated given the fact that the Rand circulates as legal tender and the Central Bank is unable to deternine exact amount of Rand in circulation. 12 CHAPTER Two THE COMMERCIAL BANKING SECTOR A. BACKGROUND 43. Lesotho's economy is closely linked with South Africa and the commercial banking sector has traditionally operated in a free market environment where there has been a virtually free flow of funds between the two countries. This relationship includes the ability to transfer funds to take advantage of interest rate differentials under situations of excess liquidity, cross border investment opportunities, and trade finance transactions. 44. Lesotho's banking sector experienced severe distress in the late 1980s and early 1990s. A number of factors contributed to the crisis: large government intervention in the banking sector resulting in poor financial institution operational performance, weak business process and poor management. Moreover, the system's performance was undermined by an inefficient judicial system and poor financial sector policies, including a weak regulatory framework and lax banking supervision, a rigid interest rate structure, sectoral credit allocation, and subsidized lending. 45. A financial sector reform agenda was implemented by Lesotho to address the problems of the banking sector with some assistance from the World Bank under a privatization project. Lesotho's banking sector reforms gained momentum in 1999 when the legal framework for the financial system was overhauled. In 1999 and 2000, CBL and the Government made changes to the Financial Institutions Act 1973 and the Central Bank Act of 1978 in order to give more powers to the Central Bank to supervise the financial sector, introduce indirect monetary control instruments and to deregulate entry of new banks into the financial system. The new Central Bank Act broadened the powers and mandates of the central bank. It gave due recognition to the market mechanism and empowered the central bank to supervise financial institutions while pursuing monetary policy by using market-based instruments. In addition, the government in most instances, reduced its ownership in banks with the largest commercial bank liquidated (the Lesotho Agriculture Development Bank-LADB) and the second state owned bank (Lesotho Bank) fundamentally restructured and privatized with the sale of a 70% share to Standard Bank. 46. However, the recent macroeconomic conditions have not created ideal conditions for financial sector development. The slowdown in economic activity since 1998 compared to the decade ending in 1997 (an average 6 percent of GDP growth) is reflected in the level of commercial bank activity in Lesotho. The aftermath of the 1998 political and social unrests is characterized by weak demand for credit, high liquidity levels in the banks, and minimal growth in deposits. Broad money and credit to the private sector declined in 1999 and 2000. This decline was exacerbated by the closure of LADB and its nationwide branch network and the Lesotho Bank restructuring. 13 Figure 2: Evolution of Financial Development Indicators (1997-2001) Financial Sector Developement Indicators 40 - 35 30 25 - r- M2/GDP 20 -. -U- Credit Priv. Sect.! GDP 15 - Deposit/GDP 10 1997 1998 1999 2000 2001 Years Source: CBL and staff estimates B. STRUCTURE AND RECENT PERFORMANCE OF THE BANKING SYSTEM Structure: 47. Lesotho now has three commercial banks, Nedbank Lesotho Ltd., Standard Bank Lesotho Ltd., and Lesotho Bank 1999 Ltd., all of which are foreign controlled. Nedbank was established in Lesotho in 1995 when it took over the operations of Standard Chartered Bank. It currently focuses its operations on corporate, business and VIP/personal customers and has a 28 percent market share in loans and advances. 48. The current Standard Bank started its operations in Lesotho in 1995 when it took over Barclays Bank operations. Initially, the bank intended to keep the Barclays corporate focus but over the last three years, it expanded to include retail banking. Following a partial liquidation and restructuring of the state owned Lesotho Bank in 1999, Standard Bank purchased a 70 percent share in the bank and has assumed management control, thus providing Standard Bank with a large retail base. With the infrastructure acquired from Lesotho Bank, the Standard/Lesotho Bank Group now has branches in 19 locations and 16 ATMs. Consequently, while Lesotho Bank's existing branch structure, client base, and investment portfolio is quite different than that of Standard Bank, management policies and practices including interest rates and products offered are now virtually identical. 49. Therefore, from a competition perspective, Lesotho essentially has only 2 banks both of which are conservatively managed and pursue conservative lending strategies. Although there are no other financial institutions that compete with the banks in Lesotho, there is significant but unquantifiable competition from banks in South Africa, mostly on the corporate banking side. Anecdotal evidence suggests that roughly 25 percent of Lesotho generated deposits are held in South Africa. 14 Banking system trends 50. Source and Uses offund: Lesotho's banks had about M 2.3 billion (about US $ 290 million equivalent) in total assets as of December 31, 2002. Total deposits of M 1.92 billion represented 30 percent of GDP which is high relative to other countries in Africa. On the other hand, net loans and advances added to only M 230 million, an extremely low 17.6 percent loan deposit ratio. Gross loans represent a very low 5 percent of GDP as of December 2002. It is noteworthy that the banking system's balances with banks abroad, representing 15 percent of total assets is considerably larger than the loan portfolio and a large but unqualified percentage of its marketable securities (which constitute over 52 percent of total assets) is also invested outside Lesotho. In addition, both banks have very large sound parent banks in South Africa. Table 8: Lesotho: Balance Sheet For The Banking System 1999-2002 (Million Maloti)'3 1999 2000 2001 2002 Cash 35.8 50.4 51.8 54.3 Balance with CBL 538.0 458.2 76.4 147.7 Balance w local banks 0.1 2.4 3.2 50.8 Balance w banks abroad 393.8 439.2 480.3 349.0 Marketable securities 652.2 818.7 1,073.8 1,215.2 Investment in subsidiary 0.0 0.0 0.8 0.8 Loans & advances gross 237.3 223.8 272.8 318.5 Provisions 20.9 26.0 25.6 32.5 Loans net 216.4 197.9 247.1 286.0 Fixed assets 70.4 102.8 108.0 103.4 Other assets 42.5 51.5 102.2 117.8 Total assets 1,949.2 2,121.0 2,143.6 2,325.0 Balances due to local banks 61.2 92.3 0.0 22.6 Balances due banks abroad 23.4 68.3 60.5 70.0 Deposits 1,640.4 1,629.4 1,744.7 1,923.0 Demand deposits 523.5 555.7 669.5 841.8 Savings deposits 520.6 492.8 521.9 561.5 Time deposits 558.4 529.4 513.2 519.6 Deferred pay accounts 37.9 51.5 40.1 0.0 Other liabilities 86.3 170.4 158.0 123.9 Minority shareholder interest 0.0 0.0 17.7 17.2 Share capital 36.5 36.5 36.5 36.5 Other reserves 101.4 124.1 126.2 131.7 Net worth 137.9 160.6 162.7 168.2 Liabilities and net worth 1,949.2 2,121.0 2,143.6 2,325.0 Contingencies & commitments 111.0 60.5 103.3 35.4 Source: Commercials banks audited annual reports 51. The banking system is growing relatively slowly. Over the four years ending December 2002, total assets grew 6.1 percent per annum, net loans by 9.7 percent (from a very low base), and deposits grew 5.4 percent on average. As inflation averaged 6.5 percent per annum over that period, total deposits (down 1.1 percent per annum) and total assets declined in real terms. 13 Individual balance sheet and income statement in Annexes 2 to 7 15 52. Deposits represent an increasing percentage of banks' funds. As of December 2002, non-interest bearing demand deposits, which tend to be relatively stable, represented 44 percent of total deposits up from 32 percent in 1999. Time deposits, which typically have maturities of three to six months, represented 30 percent of total deposits, a decrease from 34 percent in 1999. Interbank borrowing added to 5 percent and capital to 7.4 percent of assets. 53. Loans comprised only 12% of total assets in 2002, while banks invested 52% of assets in marketable securities (virtually all Lesotho and RSA government securities) and 15% of assets in banks abroad. 54. On a positive note, the composition of banking system lending, shows that a relatively high 23.1 percent of total loans have a maturity of over one year although only 1.9 percent of total deposits are for periods of over one year demonstrating that banks are willing to engage in significant term transformation. Lending is heavily concentrated in terms of credit risk as the 20 largest borrowers account for more than 50% of total loans outstanding as of December 2002. 55. The sectoral breakdown of loans and advances by the three commercial banks appears to be fairly diversified with credit to manufacturing, construction, transport and communication, trade and community services ranging between 14 to 24 percent of the total loans portfolio as of December 2002. However, lending to construction declined from over 29 percent of total lending in 1997 to 14 percent in 2002. In 1999 alone the value of credit outstanding to construction dropped form M163 million to M75 million reflecting the LHWP winding down and its effect in terms of residential and access road construction. Loans that are agriculture-related account for only 0.2 percent of total lending and manufacturing (inclusive of mining and quarrying) adds to about 16 percent. The virtual absence of lending to agriculture following the liquidation of the LADB is an important economic issue as agriculture is responsible for about 17 percent of GDP. 16 Table 9: Sectoral distribution of bank loans (Million Maloti and percent) Economic sector 1997 1998 1999 2000 2001 2002 Amount % of Amount Amount Amount Amount Amount % of total total Agricultural sector 19.0 3.1 14.0 1.0 0.9 1.2 1.2 0.2 Mining 1.2 0.2 0.9 0.9 0.8 0.8 0.8 0.1 Manufacturing (industrial) 72.7 11.9 73.8 56.3 63.4 116.6 122.3 17.4 Electricity, Water, Gas 77.4 12.6 110.6 46.2 28.5 6.5 8.6 1.2 Construction 179.8 29.3 163.1 75.8 55.8 126.2 100.4 14.3 Trade, Restaurants, H6teI 62.0 10.1 58.2 57.5 89.6 113.7 115.4 16.4 Transports & Commnunications 58.2 9.5 55.0 82.9 98.0 163.6 169.6 24.1 Insur., Real estate & other Serv. to Enterp. 66.0 10.8 63.3 39.8 20.4 44.7 44.5 6.3 Community, Social and personal services 76.8 12.5 67.9 64.6 60.6 125.6 140.1 19.9 TOTAL 612.9 100.0 606 8 425.0 418.0 699.0 702.8 100.0 Business 489.4 79.8 403.2 319.8 338.9 651.6 654.3 93.1 Statutory bodies 124.3 20.3 203.6 105.3 79.2 48.4 42.8 6.1 Source: Central Bank of Lesotho 56. Profitability: Despite the low levels of lending, the banking system was very profitable during 2002 earning a net profit of 2.6 percent on average assets and 28.4 percent on end of period equity (Table 10). Although the banks' overhead costs were high (8.1 percent of total assets) this was more than offset by an extremely robust net interest margin of 8.9 percent and non interest income of 4.0 percent of total assets. Spreads were very high with a spread on lending of 12.6 percent and an overall spread on interest bearing assets and liabilities of 9.8 percent. The high margins and spreads are remarkable given that deposits are invested primarily in very low risk balances with banks and government securities. 57. Commercial bank overhead costs are probably reasonable given the situation in Lesotho but the organizational and operational efficiency of banks has clearly deteriorated in recent years (table below). Banking system operating expenses increased sharply from 4 to 8 percent of total assets between 1999 and 2002 while the ratio of overhead to total income (net interest income plus operating income) increased from 39 to 63 percent over the same period. Foreign banks tend to have high staff costs (a primary cause was staff expense which increased far more rapidly than total revenues) and high technology costs throughout Subsaharan Africa and there are significant economy of scale problems in operating independent banks in such a small market. 17 Table 10: Summary Income Statement of Lesotho's Banks (1999-2002) (Million Maloti and percent) 1999 2000 2001 2002 Interest income 163.2 185.8 186.0 233.0 Interest expense 53.5 59.3 53.6 70.0 Net interest income 109.7 126.5 132.4 163.0 Other operating income 32.9 44.5 55.6 72.6 Total income 142.5 171.0 188.0 235.6 Staff costs 26.7 45.2 51.8 61.4 General adnin expense 20.5 29.5 32.8 41.5 Other operating expense 8.3 12.0 23.5 45.8 Total overhead 55.6 86.7 108.2 148.7 Provision for bad debt 0.5 0.7 3.0 12.5 Profit before tax 86.5 83.6 76.8 74.3 Tax 30.7 29.4 27.5 26.6 Profit after tax 55.8 54.2 49.3 47.7 Income statement/avg assets Interest income 11.4% 11.4% 11.0% 12.7% Interest expense 3.7% 3.6% 3.2% 3.8% Net interest income 7.7% 7.7% 7.8% 8.9% Other operating income 2.3% 2.7% 3.3% 4.0% Total income 10.0% 10.5% 11.1% 12.8% Staff costs 1.9% 2.8% 3.1% 3.3% General adrin expense 1.4% 1.8% 1.9% 2.3% Other operating expense 0.6% 0.7% 1.4% 2.5% Total overhead 3.9% 5.3% 6.4% 8.1% Provision for bad debt 0.0% 0.0% 0.2% 0.7% Profit before tax 6.0% 5.1% 4.6% 4.1% Tax 2.1% 1.8% 1.6% 1.5% Return on Assets 3.9% 3.3% 2.9% 2.6% Return on Equity 40.4% 33.7% 30.3% 28.4% Overhead/net income 39.0% 50.7% 57.5%1 63.1% Source: Commercials bank audited annual reports 58. Resilience of the banking system: Restructuring of the Lesotho Bank and the LADB liquidation have improved the resilience of the banking system since 1999. On an overall basis, the banking system is sound with a combined equity to total assets of 7.2 percent and a far higher equity to risk weighted asset ratio (roughly 35%) because of the high percentage of total assets (about 80%) invested in zero risk-weighted investments. Each individual bank is very sound. Banking system non-performing loans were a surprisingly low 7.1 percent of total loans, representing a steady drop from 15.3 percent on average over the previous two years. Since Lesotho's lending environment is very high risk, this suggests that the banks have pursued highly conservative lending strategies which, while justified in terms of profit objectives, exacerbates serious access to credit deficiencies in the system. The banks are extremely liquid with 25.9 percent of total assets invested in cash and bank balances and an additional 52.3 percent invested in marketable securities, primarily T-bills in Lesotho and South Africa. 18 59. Primary issues related to the banking system discussed below include i) inadequate competition; ii) funding outflows to South Africa; and iii) low levels of lending overall and specifically with respect to agriculture, small scale borrowers, and project finance. C. SELECTED ISSUES AND RECOMMENDATIONS 60. Competition in the banking system. Activity in the banking sector is concentrated. As of December 31, 2002, Standard Bank and Lesotho Bank, on a combined basis had a 65.8 percent market share of assets, a 63.4 percent share of deposits and a 72.4 percent share of loans. The Standard Bank Group share of loans increased during 2002 while its market share of deposits decreased. Standard/Lesotho Bank, with its 19 branches, has a virtual monopoly over retail banking in Lesotho as Nedbank, with 5 branches, is a niche player focusing primarily on serving the largest corporate clients most of whom are South African controlled. Management informed the mission that 95 percent of Nedbank's loans go to 5 percent of its clients. The primary competition at the retail level comes from South Africa as there are no NBFIs in Lesotho that can compete with the banks. 61. The banks are taking advantage of the relative lack of competition to engage in what appears to be de facto cartel-like pricing with interest rates consistently well below those in South Africa on deposits and lending rates consistently higher despite operating within the same common money market. As a result, the banks are very profitable and, despite doing little lending, have high interest rate margins and high spreads. The prime rate is presently 17 percent, lending rates can be as high as 27 percent depending on risk, 90 day treasury bills at the most recent auction paid 13 percent, while few deposit interest rates exceed 5 percent. Lesotho's largest bank estimates its cost of funds inclusive of overhead expense at 7 percent allowing robust spreads even on balances in South African banks and t-bills. There are also widespread complaints that bank charges for the same services are higher in Lesotho than in nearby banks in RSA and CBL is currently doing a study to verify the extent to which these complaints are valid. 62. Interest rates on 90 day fixed term deposits are presently 7 percent in Lesotho compared to 12 percent in South Africa, while the highest rate paid on savings accounts is 4.75 percent versus 9.25 percent in Ladybrand, South Africa just 30 minutes away across a porous border within a common money market area. Interest paid on deposits in Lesotho is also negative in real terms for most deposit products with inflation levels at 6.9 percent in 2001 and around 11 percent in 2002. Corporate clients can easily do their banking business, other than deposits needed for immediate transactions, in South Africa and appear to be doing so at increasing levels. Wealthier individuals can also move money to South Africa while poorer savers and those that are less sophisticated or located a greater distance from a South African border town are more likely to accept the lower rates paid in Lesotho. Anecdotal evidence suggests that roughly a third of corporate deposit business and 10 percent of individual deposits have moved to South Africa. This seems to be supported by levels of time deposits which are steadily dropping both in absolute levels and as a percentage of total deposits and by savings deposits which have grown by only 2.6 percent per annum over the past three years. 63. While lending rates are consistently higher in Lesotho than in South Africa it is more difficult to substantiate the extent to which this may be a result of inadequate competition. The Lesotho environment is clearly substantially riskier than that in South Africa and the higher rates are certainly to a significant extent a reflection of the higher 19 risk. The low levels of bank lending pose a far more serious problem for Lesotho's development than high lending rates do. It is the mission's view that, while increasing competition might reduce lending rates to some extent, they will always remain high until steps are taken to make the lending environment less risky. 64. The high minimum capital level required (M 10 million equivalent to USD1.25 million)for the entry of any credit company (leasing, hire purchase and bank branches) and the absence of other differentiating requirements and enabling legislation between banks and nonbank institutions limits the number of viable institutions likely to be established in Lesotho. This in turn creates a substantial barrier to entry which has adverse effects on competition and efficiency. D. RECOMMENDATIONS 65. Inadequate competition is Lesotho's most serious financial sector issue at this juncture and the following actions are recommended to address this issue. 1). As discussed below in the NBFI chapter, proposed amendments to the Financial Institutions Act 1999 should be drafted to allow for the licensing of nonbank financial institutions under conditions that differ as appropriate from those pertaining to banks including significantly lower minimum capital requirements. Institutions with an "NBFI or Tier Two" license should not be allowed to take demand deposits and other specified deposits from the general public as institutions with smaller capital are likely to be riskier than full commercial banks and to ensure an equal playing field among demand deposit takers. The entry of tier two players, while not increasing competition with respect to demand and savings deposits from the general public, would increase competition for other deposits, increase competition in lending and, more importantly, increase access to credit for smaller and riskier borrowers than those the two foreign banks presently lend to. 2). Consideration should be given to allowing new banks to be licensed to do business with a tier two license and lower minimum capital requirements. Cooperative banks that take deposits from nonmembers, the proposed Postal Bank and possible smaller new domestically owned banks might be candidates for tier two licenses. Cooperative banks that take more than a certain level of deposits from nonmembers, should be required to obtain a license from CBL and become subject to its supervision. 3). A study should be undertaken as to whether or not foreign bank branches should be allowed to operate in Lesotho with a tier two license. This would increase competition in the blue chip corporate niche market, but might do little to increase competition for retail business. 4). Banks should not be allowed to take advantage of the present monopoly conditions to pay significantly below market rates for savings deposits. They are being subsidized by savers and the low rates drive deposits to South Africa and reduce the incentives to save. Therefore, the CBL should use moral suasion to cause banks to raise deposit rates to the levels prevailing in South Africa and to maintain such rates as a minimum thereafter. 20 66. Funding Outflows to South Africa: Very low competition combined with low credit has lowered deposit rates (market deposit rates are significantly negative in real terms) and has led to a considerable build-up in banking system liquidity. Figure 3: Interest Rates in Lesotho and RSA (1997-2002) 20 18 - . .fr .t - , ;-s '-.i, ,rs;i t-s-i- v i +Ls. Banks' Prmerat 12 ..'-'" --'r.mE -!asTimedepositrate - ;' .;L Sa. Banks' Prime rate 8 ii - - Sa. Time deposit rate 4 , 4; ie- 1999 2000 2001 2002 Year Source: CBL 67. In addition to increasing levels of Lesotho-based banking business being undertaken directly in South Africa, the commercial banking system is moving increasingly substantial amounts of money into South Africa for investment. The level of banking system net assets shifted abroad (the vast bulk to South Africa) increased from 11.4 percent of total assets in September 1999 to 24.5 percent as of September 2002 and it appears likely to continue to increase over the intermediate term. Most countries have an effective tool for controlling such massive losses of financial resources through a prudential net foreign exchange exposure requirement. This does not apply in Lesotho because moving Lesotho exposure into Rand exposure does not increase foreign exchange risk for the foreseeable future. Direct controls to reduce these outflows are inappropriate and unfair because, indeed, banks have inadequate sound investment opportunities within Lesotho. While controls could increase incentives to lend in Lesotho at the margin, this would be more than offset by the significant reduction in incentives to mobilize deposits in Lesotho or for new banks from South Africa to enter the market. However, the costs to Lesotho development of these funds outflows is possibly significant. 68. Increasing Access to Credit and Long-term finance from the Banking System: Banks are the only formal financial institutional source of credit in Lesotho although some money lenders, credit cooperatives, and informal microfinance institutions exist. Lending levels, with a 2002 net loans to deposit ratio of 14.9 percent for the banking system, are small relative to deposits and the probable levels of effective demand in Lesotho. The banks are very cautious, usually requiring 100 percent sound collateral, and being reluctant to lend to new and smaller clients. When they do lend, interest rates tend to be somewhat higher than in South Africa, reflecting the high risk environment. While the larger, more established SMEs and large SA based enterprises have access to the formal financial sector, credit to a large number of local enterprises has been constrained by a number of factors, the most significant according to Standard Bank being the poor legal and judicial 21 environment. According to banks, there is little incentive to extend outreach, given the lack of creditworthy projects (or at least properly organized and presented projects). Aside from lending to larger enterprises, banks have holdings of T-bills to meet the CBL 25 percent liquid asset requirement. 69. The legal framework is a significant deterrent to financial intermediation in Lesotho in various ways. Its fails to guarantee property rights as an instrument that can be used for collateral and does not support property rights enforcement. Laws relating to the matrimonial system in the country and the legal minority status of women are a negative structural factor that often prevents women from contracting to obtain credit. Traditionally, the majority of men work in the RSA mining sector. Therefore women, who represent more than 5014 percent of paid employment in Lesotho in 2000 and are estimated to own 2/3 of small businesses in Lesotho, are a very important part of the potential client base for credit from commercial banks. Among other things, women cannot, without the consent of their husband (or male guardian) enter into contracts sue or be sued, register immovable property in their name, act as a company director or bind themselves as surety'5. 70. Enforcement of legislation is also constrained by two factors, i.e., i) slow execution of due process manifested by slow court proceedings encourages borrowers to take advantage of the situation; and ii) lack of financial institutions' access to timely foreclosure procedures. The execution of court orders even if provided after considerable delays is rarely undertaken in a timely manner. The Commercial court established at the initiative of the central Bank in 2000 has had little in or no impact at all on the adjudication of commercial cases. This is largely attributable to resistance shown by legal practitioners to the new procedures seen as cumbersome as well as to ignorance on the part of stakeholders such as business community judges, legal practitioners. 71. There is also a strategic reluctance on the part of banks, especially Nedbank, to become involved in what it perceives as the time-consuming and risky business of retail lending in the absence of adequate credit assessment information tools. There is no credit bureau in Lesotho. The central bank in collaboration with commercial banks is considering setting up a credit bureau. However, the absence of a unique personal identification system represents an important constraint in setting up a credit bureau. 72. The banks' behavior, while unfortunate from a developmental perspective, represents appropriate behavior on their part as Lesotho is at this juncture an unusually risky lending environment because of the legal system, land and matrimonial policies, lack of credit information systems, and large inadequately addressed bad debt portfolios of the recently liquidated banks. The disastrous financial performance of the LADB and the old Lesotho Bank provide evidence of the serious problems in the credit environment and may well have exacerbated the situation as most of their bad debts have never been collected. In addition, the Commercial Court, established as an extension to the High Court in 2000, has had little impact on the adjudication of commercial cases. This is largely attributable to ignorance on the part of stakeholders such as judges, legal practitioners and the business community as well as resistance shown by legal practitioners to the new procedures. 14 Lesotho Bureau of Statistics, Labor statistics 15 The "Married Persons Equality Rights" written by the Law Reform Commission in 2002 is still under review 22 73. In the mission's view, lending by private banks will never reach satisfactory levels unless and until the Authorities take aggressive steps to significantly improve the credit disciplinary environment. Recommendations include the following: 1) Take steps necessary to remove all obstacles to effective functioning of the commercial courts including streamlining procedures for registering "bonds" or claims against collateral and providing technical assistance to practitioners on financial sector operations; 2) Ensure that a credit information bureau is functioning effectively; 3) Establish a system that ensures that each privately owned property has a unique legal address; 4) Take steps necessary to ensure that the old bad loans of Lesotho Bank and the Agricultural Bank are collected in all cases except where borrowers have no capacity to pay; and 5) Amend the clauses in the Matrimonial Act that do not allow married women to borrow without their husband's signature. 76. With respect to long-term finance, commercial banks are essentially the only source in Lesotho at this juncture with the exception of one unit trust that mobilizes long-term finance to purchase equity shares in selected companies that are being privatized. There are no leasing companies, no finance companies, and no development finance institutions that now make loans. Contractual savings institutions invest funds to the maximum extent possible in South Africa and engage heavily in reverse term transformation in Lesotho, i.e., turning long-term funds which are potentially valuable inputs to development into less useful short-term funds. 77. Commercial banks are mobilizing relatively little long term funding. As of September 2002, the system had about M 35 million or roughly 30 percent of its deposits in 180 day maturities or longer, but only around 2.5 percent of deposits are for periods of over one year. Nonetheless, operating under guidelines identical to those in South Africa, they are able to do considerable term transformation through making loans for up to 5 years and report that 24 percent of their lending is for more than one year. Unfortunately, this adds to only M 75 million given the low loan deposit ratios in Lesotho. The banks informed the mission that they are, in principle, willing to do considerably more term lending than now takes place and that it is effective demand and credit environmental constraints, not the supply of funds, that is the primary obstacle to increased commercial bank term lending. However, conservative collateral policies combined with issues associated with using land as collateral make the banks a relatively poor source for project finance, with the exception of small expansions. 78. Lesotho Bank, as of December 2002, has a hire purchase (leasing) portfolio adding to M33 million (up from M25 million one year earlier) and a housing loan portfolio adding to M 18 million. It is cautiously but steadily increasing lending in these arenas, offering 5 year hire-purchase loans for vehicles at a rate of prime plus 5 percent and offering 15 year home mortgages at an interest rate of prime plus 1 percent. Both of these products are now sold on a variable rate basis which protects the bank from direct interest rate risk, but could expose it to substantial non-performing loans, especially on the home mortgages, if interest rates were to increase sharply and raise required payments above borrowers' ability to pay. 23 The new activity in these arenas continues but on a much more conservative basis than Lesotho Bank's pre-1999 operations. 24 CHAPTER THREE NON BANK FINANCIAL INSTITUTIONS A. INTRODUCTION 79. Nonbank financial institutions (NBFIs) typically target specialized niches of savers and investors developing their comparative advantages in areas where banks have limited ability to provide adequate services (such as equity finance, long-term finance, credit to industry and housing and small scale saving services). By extending financial services beyond the range typically offered by commercial banks, NBFI's increase competition and efficiency in the financial sector as a whole, extend the range of available options, and enhance ability of savers and investors to manage economic risks. 80. In addition to its banks, Lesotho has 6 insurance companies, 2 development finance institutions (Lesotho National Development Corporation and Basotho Enterprise Development Corporation), the recently established Standard Bank Lesotho (SBL) Unit Trust and a Corporate Bodies Pension Scheme (administered by the Lesotho National Insurance Corporation). 81. The NBFI sector is relatively underdeveloped and, by the end of 2002, accounted for only 11 percent of total assets in the financial system (excluding CBL). Furthermore, as none of these NBFIs collect deposits or make loans and as they invest mostly in RSA, they represent no meaningful competition for Lesotho's commercial banking system, thus exacerbating the already unsatisfactorily low level of competition in banking. 82. The dominance of state-owned insurance companies, and a poor regulatory environment for NBFIs have suppressed the establishment of private NBFIs which has in turn inhibited the development of new financial instruments even in the quite favorable macroeconomic environment of the 90's. B. THE INSURANCE INDUSTRY 83. Lesotho has six insurance companies in general and/or life insurance'6 including (i) the Lesotho National Insurance Company (LNDC) made up of the Lesotho National General Insurance Corporation (LNGIC) offering vehicle and other short term insurance products and the Lesotho National Life Insurance (LNLI) offering life insurance; (ii) Alliance Insurance which is still fairly small and is the only competitor to LNIC in the general insurance market; (iii) the newly established Sentinel Insurance; and (iv) Metropolitan Life which sells only life insurance. In addition, some insurance products are sold by South African companies that are not licensed in Lesotho, especially for motor vehicles which are often purchased in South Africa. Annual gross premiums are roughly equally divided between general and life insurance. The table below shows that total assets of the insurance industry grew by 11 percent per annum on average between 1998 and 1. An international consulting group has been recruited under the FIRST initiative to do a comprehensive study of Lesotho's insurance industry and its regulation and supervision. They have already initiated work and an initial report is expected soon. Therefore, this study has not examined the insurance industry in any depth. 25 2001. Gross written premiums amounted to M129 million in 2001, down sharply from M185 million in 2000. These data suggest insurance penetration in Lesotho of roughly 2 percent of GDP which is low, but higher than in some other African countries. Table 11: Total Assets And Insurance Penetration In Lesotho 1998 1999 2000 2001 Total assets 198 216 231 271 Gross premium 164 173 185 129 Gross Premium in % of GDP 3.3% 3.1% 3.0% 2.1% Source: CBL and staff estimates The Lesotho National Insurance Company (LNIC) 84. LNIC is the largest insurance company in Lesotho. It is 50 percent government owned, with the remainder owned by two foreign insurance companies (that reportedly wish to disinvest by selling their shares back to government). In 2001 (the last year for which data are available), the group had total assets of M 210 million, a M 200 million investment portfolio, and stated net worth of M 37 million (17.8 percent of portfolio). If pension fund assets which LNIC administers are deducted (as they should have been), its total assets would be reduced to M 155 million. LNIC wrote M 78 million in gross premiums in 2001, of which M 59 million (76 percent) was for short-term general insurance, and M 19 million was life insurance. 85. The insurance market has traditionally been heavily dominated by the government controlled LNIC in general insurance and, to a lesser extent, by Metropolitan in life insurance. Meaningful competition is only now beginning to develop with the rapid growth of Alliance (from a very small base) and the recent entry of Sentinel, both privately controlled companies. 86. LNIC's market share 17 is roughly estimated at 60 percent for general insurance and 15-20 percent for life insurance. The company made a small loss in 2001 and competitors express the view that it is not particularly well managed. Management reported that its life insurance business is being severely undermined by the relatively high incidence of AIDS. Despite being controlled by Government, anecdotal evidence suggests that the company keeps the minimum if not less than the minimum investment in Lesotho required under the insurance regulations. 18 Overall, LNIC remains sound as most assets are conservatively invested and exposures are regularly evaluated actuarially. However its financial condition is not transparent because the pension fund is incorrectly accounted for, and the company's financial condition and performance are deteriorating. 87. The 2001 audited statements showed a loss of M 1.1 million (5% of average total assets) in 2001. As the auditors qualified these accounts by referring to M 6.4 million in a prior year adjustment and in debits to premium income as "estimated figures that could not 21 Market shares are difficult to estimate because companies have different year-ends, the supervisor receives only an annual report consisting primarily of the audited statements and does not have reports from all companies. Also, Metropolitan Life Insurance Company does not report its Lesotho activity separate from South African activity because, until a month or two ago, it had only an agency presence in Lesotho. A consensus estimate of market size provided by insurance company executives in interviews with the mission suggest total gross premiums of about M 210 million of which roughly half was for short-term general insurance. Is Articles 29 and 30 of Part IV of the Insurance Act require all insurers to keep invested in Lesotho the sum of the amount required to meet the liability undertaken by life insurers, the amount required to meet the liability on account of matured claims under life insurance policies, forty percent of the gross direct premium written on own account in Lesotho for general insurance business, and the amount required to meet the liability on account of outstanding and unsettled claims under general insurance policies (net of reinsurance) 26 be substantiated" LNIC may already be making substantial losses. Decisive action, e.g., privatization, may need to be taken soon to address this performance issue and to protect the pension fund the company manages. 88. LNIC may have an unfair advantage over its competition in that, while income tax is payable on short-term insurance business profits, the group is not liable for income tax on its long-term assurance business surplus other than group life insurance. It is unclear what this advantage may amount to in terms of value because pension fund assets are not treated separately from LNIC assets in its financial statements but LNIC should be treated identically to other insurance companies in terms of taxation to create an equal playing field. 89. Two private domestic insurance companies, Alliance and Sentinel, are engaged in writing both general and life insurance business. Alliance has been operating now for more than 5 years and as of December 2002 has total assets of M 29 billion, a net worth of M 7 million (28 percent of assets), and a M 1.7 million profit (24 percent on equity). It had gross premiums of M 33 million (a 35 percent market share) in short term business and M 2 million (roughly a 2 percent market share) in life insurance. Sentinel began operations within the last year and its market share is, at this juncture, insignificant. 90. Metropolitan Life is based in South Africa and, although it has operated for many years in Lesotho, has not yet produced any Lesotho specific financial information. The company is substantial with R 5.4 billion (equivalent to M 5.4 billion) in total assets, net worth of R 5.3 billion, and a 2001 profit of R 2.8 billion. It estimates its annual Lesotho premiums at about M120 million per annum and estimates that it maintains a 60-65 percent market share in life insurance. The company registered to do business in Lesotho in January 2003 and expresses the intent to file the required reports and pay tax in Lesotho on an ongoing basis. 91. The insurance industry, to the extent that it invests in Lesotho, is a potentially significant source of long term funds with total investments exceeding M 200 million in 2001. However, long-term investment by life insurance companies in Lesotho is insignificant as LNIG, the only significant source of life insurance sourced funds in Lesotho, had total investments of about M 145 million of which an estimated 45 percent is invested in t-bills and bank deposits which for the most part are for one year or less. Metropolitan, which reportedly holds a 60-65 percent market share of the life insurance business, prior to setting up a licensed operation in Lesotho in early 2003, presently has invested only in South Africa, keeping only transactions balances in Lesotho. Alliance, which has somewhat less than a 10 percent share (M3 million in annual premiums), invests the absolute minimum required by law in Lesotho because the interest rates are so much lower than in South Africa and all money in Lesotho is invested in call deposits at 5 percent interest. Sentinel is still too new to have significant balances available for investment. 92. There are widespread complaints that insurance rates are higher than for similar coverage in South Africa. Level of claims relative to gross premium income provides some support for these complaints. However, with Sentinel coming into the market and Metropolitan upgrading its presence in Lesotho, competition is now increasing and rate levels are likely to slowly decrease if there is no repeat of problems such as those that occurred in 1998. There is also some competition from South Africa, especially in motor vehicle insurance. The mission does not believe it is necessary at this time to allow Lesotho 27 insurance brokers to place insurance with South African insurers to bring insurance rates down to more competitive levels. 93. The insurance industry is poorly regulated and supervised but efforts are now being initiated to make improvements. The central bank has responsibility for its oversight and the Governor is the Commissioner of Insurance. The industry is regulated under the Insurance Act of 1976 and Regulations which were enacted in 1985. At the time of the mission, only one insurance company has ever been inspected, the only reporting requirement was an annual report consisting primarily of the audited financial statements, and not all insurance companies have reported. Several insurance company managers interviewed by the mission appeared largely unaware of what they were required to do under the law and regulations. Although CBL has 12 staff working in its financial institutions department, no one has been made specifically responsible for insurance. 94. An international consulting group has been recruited under the FIRST initiative to do a comprehensive study of Lesotho's insurance industry and its regulation and supervision. They have already initiated work and an initial report is expected within the next month or two. Therefore, the mission has not examined these issues in any depth. 95. CBL is not particularly well placed to supervise the insurance industry given its small size and the extent to which the subsector is represented by South African companies and invests most of its funds in South Africa. It distracts from CBL's ability to supervise the more important banking industry and effectively conducting ongoing supervision of insurance companies is costly given significant economy of scale constraints. On the other hand, no other entity in Lesotho would have a comparative advantage vis. CBL in supervising the insurance industry. Therefore, as a broad ranging view of insurance regulation and supervision is now taking place, the mission recommends that the feasibility of harmonizing insurance laws and regulations more closely with those in South Africa and subcontracting responsibility for supervising the insurance companies in return for a fee be investigated prior to making final decisions as to how best to supervise and regulate the industry. 96. Recommendations relating to the insurance industry should, for the most part, await the findings of the consultants. If CBL continues to supervise the insurance industry, we have several recommendations as follows: 1). The Central Bank should immediately identify at least one Financial Institutions Department staff member (the consultants may recommend more than one) who will work full time on insurance and be responsible for ensuring that reporting requirements are met and for reporting on the status and condition of the insurance industry; 2). All insurance companies should be required to adopt the same financial year for reporting purposes; 3). Insurance companies should be required to file quarterly reports which inter alia provide information on what the investment portfolio consists of, what portion thereof is in Lesotho, and whether or not investments are in compliance with the requirements; 28 4). LNIG should be required to provide a detailed annual audited report on the Corporate Bodies Pension Scheme which provides information on its assets, liabilities, investment results, inflows of contributions, payment of benefits, number of participants, etc. Pension scheme funds and operations should be completely separated from those of LNIG in its accounting and, thereafter, LNIG, like its competitors, should be required to pay tax on all of its profit before tax, regardless of source; and C. DEVELOPMENT FINANCE INSTITUTIONS 97. Lesotho has two development financial institutions (DFIs): the Lesotho National Development Corporation (LNDC) and the Basotho Enterprise Development Corporation (BEDCO), neither of which collects deposits or engages in new lending. As of December 2000, these two institutions had a combined M312 million in total assets (US$ 41 million equivalent), constituting roughly 4% of financial system assets. 98. A third development bank, the Lesotho Agricultural Development Bank (LADB) performed extremely poorly and was liquidated in 1998. Before its liquidation it had grown very rapidly, reaching M 110 million in deposits and M 50 million in loans by 1995, and continuing to grow thereafter. Lesotho has not found a significant source of credit for agriculture to replace LADB, a situation that represents a serious issue for the economy. 99. Lesotho's financial sector has been fundamentally changed and subjected to substantial stress by the elimination of these three institutions as development lenders. Sources of ongoing project finance have largely dried up in Lesotho because these three institutions are no longer lending. Moreover, their poor lending practices have contributed toward creating an undesirable credit culture and reputation which cause potential new lenders to be reluctant to take credit risk that is not extremely well collateralized. LNDC and BEDCO are briefly analyzed below in view of their past role as financial sector. Intermediaries. Lesotho National Development Corporation (LNDC) 100. LNDC is a govermment owned 9investment company which was formed in 1967 as the sole industrial and commercial development parastatal body in Lesotho. It operated for many years under Ministry of Trade and Industry direction and under its own Act. The legislation was amended in 1990 and 2000 but the mandate remained to initiate, promote and facilitate the development of manufacturing and processing industries mining and commerce. In broad terms, LNDC seeks to meet its development responsibilities by making equity and loan investments in enterprises falling into the medium to large category within Lesotho, and by encouraging foreign investment through assistance with joint venture formation and provision of industrial sites and premises. 101. At one time LNDC did substantial lending, relying on government grants and lines of credit from institutions such as the European Investment Bank, the African Development Bank, Commonwealth Development Corporation (CDC) and IDA and was a substantial source of long term loans and equity for project finance. However, loan performance was so poor that it eventually led to a decision to phase out term lending. 19 DEG of Germnany invested in a nonvoting preferred share issue in 1986. 29 102. LNDC is now primarily involved in promoting medium and large scale industrial investment, developing commercial real estate and industrial estates, and entrepreneur development. It still has a substantial equity portfolio valued at M 35 million consisting of 13 holdings, 7 of which are perforning satisfactorily. The 51 percent holding in the Lesotho Brewing Company, its largest equity investment (net of provisions), is a major source of dividend income. While LNDC is still collecting on few past loans and has small unutilized amounts still available under an ADB line of credit, it has completely stopped any new lending or equity investment (with the exception of commercial real estate) because of large financial losses from these activities. LNDC's decision to get out of new lending and equity investments appears sound in light of the very poor performance of its past portfolio. 103. However, despite its past lending losses, LNDC has a strong balance sheet as of March 2002 with net worth of M 167 million constituting almost 52 percent of total assets and net current assets of about M 40 million (a current assets to current liability ratio of 2.6). Table 12: LNDC - Unconsolidated Balance Sheet (1999 002) (00 Maloti) 1999 2000 2001 2002 Debtors 10.2 18.7 12.1 10.4 Short investments 8.4 12.5 22.9 54.2 Bank and cash 22.8 10.1 15.6 1.4 Current assets 41.3 41.3 50.6 66.1 Interest in subsidiaries 30.0 27.8 33.1 23.5 Interest in associates 3.8 1.6 3.9 3.3 other investments 7.3 8.2 9.2 10.2 long term loans 3.9 2.5 3.6 8.2 subtotal investments 45.0 40.1 49.7 45.3 fixed assets 206.7 209.6 203.5 212.2 Total assets 292.9 291.0 303.8 323.6 current liabilities 22.7 24.2 26.1 25.8 long term liabilities 134.7 134.5 130.1 130.3 total liabilities 157.4 158.7 156.3 156.1 net worth 135.5 132.3 147.5 167.5 Net worth & liabilities 292.9 291.0 303.8 323.6 net current assets 18.6 17.1 24.5 40.3 current ratio (Current assets/Current liabilities) 1.8 1.7 1.9 2.6 investments/total assets 15.4% 13.8% 16.4% 14.0% fixed assets/total assets 70.5% 72.0% 67.0% 65.6% equity/total assets 46.3% 45.5% 48.6% 51.8%1 Composition of investments interest in subsidiaries 66.7% 69.3% 66.6% 5 1.9% interest in associates 8.4% 3.9% 7.9% 7.4% other investments 16.3% 20.4% 18.4% 22.6% long term loans 8.7% 6.3% 7.1%° 18.1%1 Source: LNDC and staff estimates 104. LNDC Capital structure and source of funds: Until 1985, The Government of Lesotho remained the sole shareholder of the then M 4 million authorized and issued share capital of the corporation. In 1986, negotiations were held with the German Finance 30 Company for Investment in developing countries (DEG) for a subscription of DM I million shares in LNDC. As shown in its balance sheet (table above), following several injections of new capital by Govermment and DEG in 1988, 1990 and 1995 and capitalization of reserves, LNDC's paid-up capital added to M40 million in 2002 comprising 21 million in ordinary shares, M2 million in preference shares and M17 million in reserves owned 10 percent by DEG and 90 percent by the Government of Lesotho. Total equity stood at M168 million in 2002, up from M147 in 2001, while long term debt amounted to M130 million, representing a debt to equity ratio of 77 percent. The current ratio (ratio of current assets to currents liabilities) of the corporation itself was a very satisfactory 2.6 on an unconsolidated basis as of December 31, 2002 and a less satisfactory 1.6 if all subsidiary current assets and liabilities are taken into account. 105. Some 84 percent of LNDC consolidated long term debt at this last balance sheet date was provided through the Government of Lesotho principally from concessional foreign entities such as the International Development Association, the African Development Bank and the UK Overseas Development Agency. The European Investment Bank had two extant global lines to LNDC accounting for 11 percent of the total. LNDC directly borrowed about 15 percent of this total with the assistance of government guarantees. The weighted average interest paid on all of LNDC's borrowing is around 9 percent, well below average income received by LNDC on its equity investmnents. LNDC's audited accounts are not very specific in describing these loans which all originate in foreign currencies but the balance sheet reflects LNDC's understanding that the Government will meet any foreign currency loss that may occur for loans contracted before 1990. 106. Several of LNDC's traditional funding sources have indicated that further facilities will not be forthcoming on the scale necessary to fund LNDC's anticipated project investment. Moreover, Government, because of fiscal pressures, has reduced its direct support to LNDC and has withdrawn from providing open-ended foreign exchange loss indemnity for future LNDC foreign currency borrowing. It is therefore clear that LNDC will need to look elsewhere for funding if it is to achieve its planned future scale of investment activity which include some large new investments to respond to the need of foreign investors coming to Lesotho to take advantage of opportunities created by the recent AGOA status of the country in textiles, clothing, and footwear from East Asia and from RSA. 107. LNDC portfolio: LNDC appears to have been relatively conservatively managed in recent years and grew assets by only 3 percent per annum over the 1999-2002 time period. Of its M257 million in total assets in 2002, fixed assets accounted for over 72 percent while LNDC's investment in subsidiaries accounted for 10%. LNDC's industrial property portfolio in 2002 consists of 117 factory buildings leased out to companies mostly in Maseru, Maputsoe, Ntyense and Thetsane. 108. Long-term loans added to only M8 million including M6.9 million (85% of total loans) in respect of unrealized foreign exchange-losses on borrowings apparently agreed to be for the account of GOL20. The remainingM1.1 million in loans is of poor quality and 20 FX differences arising in the corporation's loans prior to 1990 are debited to Government of Lesotho which has agreed to provide against exchange rate changes on LNDC foreign currency borrowing. Unrealized FX losses are capitalized in the carrying amount of long term loans 31 LNDC has made a bad debt provision for most of it as of December 2002. Moreover, LNDC stopped new lending due to this poor past performance. Interest income, most of which is accrued on the loan due from Government to cover foreign exchange losses, accounted for just 10 per cent of operating income in 2002. 109. LNDC has an investment of M27 million (8.4% of assets), in equity in its 16 subsidiaries and associated companies. LNDC's use of equity accounting principles for its investments in associates, together with the full consolidation of its subsidiaries, gives a much more useful indication of the value of these investments than does their cost. There may also be unaccounted for hidden values represented by brand names, franchises and goodwill. 110. Dividend income plus revenue from rent of land and premises together contributed over 89 percent of LNDC's total income in 2002. One subsidiary, the Lesotho Brewing Company, in which LNDC acquired a 51 percent shareholding interest at a cost of over M2 million and has made further loans of over 12 million, constitutes 65 percent of the aggregate value of LNDC's total investment in subsidiaries. Such a high concentration in one investment may not be prudent but it has been a profitable investment to date and provides over 80 percent of LNDC's annual dividend income. 111. LNDC has made a provisions adding to 48 percent of the gross value of its investment in subsidiaries and associates as of December 31, 2002 suggesting that most of its equity investments other than that in the brewing company have been unsuccessful. 112. Profitability: LNDC has been profitable in recent years with a pre-audit 2002 profit of M 15.6 million (a robust 5% on total assets but only 9.3% on equity because of its unusual gearing), up substantially from profits of 3.6% of average assets the previous year. Overhead expenses dropped sharply to 4% of average total assets (from a high 9.8% the previous year) which would appear reasonable for an investment company of this type. Table 13: LNDC Financial Statements (1999-2002) (Maloti 00) Income 1999 2000 2001 2002 Dividends 29.8 20.9 22.0 25.0 Interest 3.7 4.3 3.2 6.0 Rent 14.1 22.6 26.3 27.1 Other income . 0.3 4.1 0.5 0.3 Total income 47.9 51.9 52.1 58.5 Expenses Financial expenses 5.4 12.9 12.9 12.8 Bad debt expenses 2.1 -3.9 -0.6 2.3 Overhead expenses 21.6 39.5 29.0 12.6 Total expense 29.2 48.5 41.4 42.9 Profit 18.8 3.3 10.7 15.6 Average assets 146.5 292.0 297.4 313.7 Income statement/avg total assets Dividends 20.3% 7.2% 7.4% 8.0% Interest 2.6% 1.5% 1.1% 1.9% Rent 9.6% 7.7% 8.8% 8.7% Other income 0.2% 1.4% 0.2% 0.1% Total income 32.7% 17.8% 17.5% 18.7%° 32 Financial expenses 3.7% 4.4% 4.4% 4.1% Bad debt expenses 1.5% -1.3% -0.2% 0.7% Overhead expenses 14.7% 13.5% 9.8% 4.0% Total expenses 19.9% 16.6% 13.9% 13.7% Profit as % of average assets 12.8% 1.1% 3.6%i 5.0% Profit as % of net worth 13.9% 2.5% 7.3% 9.3% Source: LNDC financial statements (audited and un-audited in 2002) 113. LNDC's M 324 million in assets constitute about 14% of commercial banking system assets, and a substantial government investment as its net worth is roughly equal to that of the entire banking system. Such a large Government investment may be creating considerably less in the way of new incremental developmental benefits than would potential alternate uses for these funds if they could be converted to cash. 114. While LNDC appears to have stabilized and is now profitable, it represents a huge financial investment by Government which appears to achieve relatively little incremental developmental impact. Moreover, LNDC could impose some fiscal cost to Government on an ongoing basis to the extent that it repays the amounts it owes. The Basotho Enterprise Development Corporation (BEDCO) 115. BEDCO was established in 1975 and put under its own Act in 1980 as a 100% government owned parastatal supervised by the Ministry of Trade and Industry to establish and develop Basotho owned enterprises. While not specified at its establishment, BEDCO focuses on supporting small scale clients in the manufacturing, trading and service sectors with loans, business extension services (mainly training) and administration of industrial estates and workshops. At one time BEDCO did substantial small scale lending but repayment perfornance was poor and led to a phasing out of this activity. BEDCO's most important activity has been the provision of premises to small scale enterprises on the industrial estates constructed with donor help. Today, it engages primarily in entrepreneur training, technical support for small scale businesses, and managing its industrial estates. 116. In 2000, BEDCO was given M 5 million to provide loans (maximum size M 10,000) to assist small entrepreneurs to recover from the impact of the 1998 riots. BEDCO planned to lend these funds during its FY 2001 and use the repayments to establish an ongoing revolving fund for lending. However, repayment was poor (only 18% of the clients repaid), so new disbursements were discontinued. BEDCO reports that it still has about M2 million in funds potentially available for disbursement and is considering a resumption of lending based on peer group guarantees at some future date. In the mission's view, it will be difficult for BEDCO to build a sustainable lending program given its noncommercial culture, expectations of its potential borrowers that loans from a government entity of this type don't need to be repaid, and the generally poor credit disciplinary environment in Lesotho. 33 Table 14: BEDCO-Balance Sheet (1997-2000) (O Maloti) 1997 1998 1999 2000 Stocks 644 422 403 351 Debtors 575 973 1,653 934 Cash 2,894 3,157 1,131 7,135 total current assets 4,113 4,552 3,187 8,420 fixed assets 3,634 6,110 11,282 12,303 gross loans 859 845 loans, net of 100% provision 0 0 0 0 total assets 7,747 10,662 14,469 20,724 creditors & accruals 1,641 3,407 2,841 2,525 current long term debt 0 782 1,165 1,597 current liabilities 1,641 4,190 4,006 4,123 long term loans 2,163 1,298 865 433 managed funds 12 13 9 9 total liabilities 3,816 5,500 4,879 4,565 share capital & grant 2,337 2,563 6,582 7,261 micro finance 0 0 0 5,000 Surplus 1,595 2,600 3,007 3,898 total equity 3,932 5,163 9,589 16,159 equity & liabilities 7,747 10,663 14,469 20,724 average assets 9,205 12,566 17,596 Source: BEDCO (2001) 117. As of March 2000 (the most recent financial statements made available to the mission), BEDCO's audited accounts show total assets of M 20 million, little debt, and net worth of M 16 million (inclusive of a M 5 million microfinance fund), adding to a robust 78% of total assets. It had a 100% provision for bad debt on M 845 million in remaining loans (i.e., all loans other than the relatively new microfinance fund) made in previous years. 118. Reported profit of M 890,000 (5% of average assets) is misleading as about half of its gross income in that year came from a M 3.65 million government subvention. Without the government subvention and unorthodox accounting which adds back a portion of previous capital grants to income, BEDCO would have lost M 2.78 million (15.8% of average assets) in its FY 2000. BEDCO's financial performance is unsatisfactory and steadily deteriorating. Indeed, in each of the four years from 1997 to 2000, BEDCO's losses before subventions increased and the size of its subvention also increased. Table 15: BEDCO- Selected Income Statement Items (1997-200) (000 Maloti) 1997 1998 1999 2000 Income Gross profit from trading 724 635 435 691 government subvention 2,100 2,500 2,630 3,653 Interest 400 501 242 263 Rental 1,699 2,067 2,378 2,733 Sundry 156 133 201 148 total income 5,079 5,836 5,886 7,487 Income excluding subvention 2,979 3,336 3,256 3,834 Expenses 34 audit fees 20 22 24 20 Interest & bank charges 14 13 17 24 other items 3,693 4,509 4,908 6,142 Depreciation 586 441 690 904 subtotal: overhead 4,312 4,984 5,640 7,089 Other items capital grant released -398 -202 -381 -479 Provision for debts recovered -53 -11 -14 total expense 3,914 4,729 5,248 6,596 Profit before tax 1,165 1,107 638 890 pnor year & extraordinary -230 Profit/loss before subvention & cap grant -935 -1,446 -2,003 -2,776 Source: BEDCO audited financial statements (2001) 119. In summary, BEDCO's balance sheet as of March 2000 was sound, but it requires large subventions from Government to operate because of large losses from operations. The mission does not view BEDCO as a financial sector institution as it ceased new lending some time ago, then involved itself for a short time in disbursing the microfinance fund before stopping that activity. BEDCO's view of its future strategy with respect to resuming microfinance lending is unclear. It is the mission's view that it is unlikely that BEDCO can develop a sustainable lending program of any type and that an effort to do so will encourage non repayment cultural trends in Lesotho. A government program which does not involve BEDCO such as those being envisaged to be implemented by CBL for providing guarantees to comnmercial banks for loans to exporters, small scale borrowers, etc. would probably be a more desirable alternative, albeit also an alternative that would probably result in substantial losses if banks could be induced to make guaranteed loans that they would not otherwise make if they are taking 100% risk. 120. Recommendations on LNDC and BEDCO 1) It is recommended that no new lending be undertaken by either LNDC or BEDCO. LNDC's equity and real estate investment portfolios should be spun off from its entrepreneur development and training activities in the form of a new company which should be privatized. A BEDCO corporate strategy study should be undertaken to i) examine the feasibility of merging BEDCO with LNDC's non investment activities and making it the single focal point for training and promotion support for both small and larger scale industy; and ii) eliminating BEDCO's lending function and recommending a collection and disposition strategy for dealing with the largely moribund BEDCO and LNDC loan portfolios; and iii) preparing a corporate strategy and business plan for BEDCO's ongoing operations. 2) If LNDC is not privatized, it should consider utilizing its strong balance sheet to provide partial guarantees for a few carefully selected, carefully appraised projects in cases where commercial banks are willing to make loans and take considerable risk if a project sponsor can find a way to increase the available collateral. LNDC might take small equity stakes in payment for such guarantees to improve selected borrowers' gearing. However, any such operations should depend heavily on an independent commercial bank appraisal and willingness to take credit risk as, in the mission's view, LNDC does not itself have the skills necessary to adequately appraise commercial risk for guarantees. 35 3) The Government should convert the remaining microfinance funds into a subvention that BEDCO with the stipulation that it not be used for lending but rather in support of its extension and/or industrial estate activities. E. OTHER NON-BANK FINANCIAL INSTITUTIONS 121. The Standard Bank Lesotho Unit Trust Management company was established in 2001 with an initial capital of M 1.5 million to manage a unit trust which presently holds roughly M 45 million owned by as many as 2000 individual Lesotho investors. It is a subsidiary of Standard Bank Lesotho Ltd. which owns 51 percent, with the remainder equally owned by two private sector companies (PMB consulting and Harley & Moris). The long-term plan is to raise M 75 million and M 1.5 to 2 million in new investment is now being raised monthly by Standard/Lesotho Bank branches. SBL is supposed to invest 30 percent of its funds in Lesotho equities, 30 percent in Lesotho treasury bills, 30 percent in other countries in the Rand Monetary Area, while keeping about 10 percent in cash available for redemptions. For the quarter ending in December 2002, the trust had invested about M 7 million in 6 month t-bills, M 1.5 million in Standard Bank Offshore Conservative Fund and M 1.75 million in Lesotho Bank 1999. It is presently negotiating the purchase of brewery shares owned by the government. The unit trust is an innovative initiative which, if well managed as it seems to be in its early stages, may make a positive capital market contribution to development and may be particularly relevant in support of future privatization. It is, however, unlikely to constitute a source of venture capital financing. Table 16: Balance Sheet of SBL Unit Trust (000 Maloti) Dec 2001 Assets Current assets 1228 Managed Units 578 Trade and other Receivable 263 Cash and equivalent 386 Non current assets 233 Property Plant and Equipment 83 Deferred tax assets 150 Total assets 1461 Equity and Liabilities Capital and reserves 1221 Share capital 150 Share Premium 1350 Accumulated loss -279 Current liabilities 240 Total equity and liabilities 1461 Source: The SBL Unit trust 122. Lesotho has no leasing companies, finance companies, or other financial institutions that could provide competition for the banks and provide the people of Lesotho with a meaningful choice of financing alternatives beyond what may be available to them in South 36 Africa. A major reason for this absence of NBFIs that provide credit is the small size of Lesotho's market. However, other reasons include the absence of a leasing law (Standard Bank does leasing for Lesotho clients only from South Africa because there are no tax advantages associated with leasing in Lesotho), the absence of a pension fund enabling act, and a Financial Institutions Act that does not differentiate between banks and nonbanks. As a consequence, most readers of the Act believe that any NBFI other than an insurance company must have M 10 million in initial capital and must comply with all other conditions of the Act that are set for commercial banks. This, given the small size of the Lesotho market, poses a substantial if not insurmountable barrier to entry of potential new competitors in a situation where new competition is badly needed. 123. It is recommended that consultants be retained to: a) Draft a Leasing Act similar, if not identical, to the parallel South Africa Act; b) Study Lesotho's pension industry and the related laws and regulations and, based on that study, assist in catalyzing the preparation of enabling legislation for the pension industry; and c) Draft proposed amendments to the Financial Institutions Act 1999 to allow for licensing of a second tier of nonblank financial institutions (especially leasing and finance companies) for which the initial capital requirement would be significantly less than M 10 million and other conditions are modified to the extent appropriate for smaller institutions of a different type. These second tier institutions should not be allowed to take demand deposits. 124. The corporate body pension system: Contractual savings institutions, especially pension plans, are typically the main source of long-term funds in Africa today. The Corporate Bodies Pension Scheme, which is operated by LNIC and covers only parastatals, is the only pension operating in Lesotho as the few significant private schemes that exist invest most of their money in South Africa and the scheme for civil servants operates on a "pay as you go" basis. LNIC does not prepare separate accounts for the pension scheme and it appears only as a line item in the financial statements of its subsidiary, the Lesotho National Life Assurance Company, Ltd. Total amount in the fund was M 54.7 million as of December 2001, down sharply from M 66.7 million one year earlier, because participating parastatals are being privatized and new owners of these companies are withdrawing from the plan. Only 9 of an original 20 participating companies continue to participate in the scheme and gross new inflows have dwindled to about M 6.6 million a year. LNIG appears to be investing pension proceeds on the same basis as its own funds, i.e., 42 percent in bank deposits, 45 percent in government paper, 6 percent in equities and 7 percent in property. Roughly 50 percent of their bank deposits and government paper, as well as all their equity investments, are invested in South Africa where interest rates are considerably higher. LNIG Management stated that most of its bank deposits are now for periods of one year or less as the banks are increasingly reluctant to take 3 year deposits. 125. Lesotho is too small a market and has too little domestic industry to support a meaningful pension industry or the costs of regulating it. The existing pension scheme serves only parastatals which are disappearing, while many large companies are South African owned and maintain their own pension programs outside Lesotho. Moreover, 37 effective pension support systems play an important social safety net role that extends far beyond financial sector considerations. 126. The mission recommends that a study be undertaken of Lesotho's pension situation with a view to i) designing the enactment of pensions regulations that are virtually identical with those in South Africa (with the exception that some requirements with respect to investing some long term funds within Lesotho might be imposed); and ii) preparing a plan for how Lesotho might rely on the South Africa supervisory authority to supervise pensions within Lesotho. 38 CHAPTER FOUR FINANCE FOR MICRO, SMALL AND MEDIUM ENTERPRISES 127. This chapter provides a picture of financial services available to micro, small, and medium enterprises (MSMEs) in Lesotho. The first section provides an overview of the productive poor in the country; the second an analysis of the financial services targeted for these enterprises; the third coverage on the policy, regulatory, and supervisory issues associated with the sector; and the fourth presents recommendations to strengthen the enabling environment to deliver financial services to the productive poor and rural MSMEs countrywide. A. OVERVIEW OF THE MICRO, SMALL AND MEDIUM ENTERPRISES IN LESOTHO 128. In Lesotho, there are more than 100,000 small and micro enterprises,2' defined as enterprises managed by 1-2 persons, with 25 or fewer employees, fixed investment of less than M100,000 and annual turnover below M500,000. Overall, they employ nearly 200,000 individuals and generally cater to the domestic market, except for producers of carpets, tapestry, leather goods and handicrafts that may sell to foreign visitors. A recent survey by GTZ22 suggests that the majority of micro and small enterprises (MSEs) are informal, Basotho-owned sole proprietorships, engaged generally in mining and quarrying; manufacturing (about 22 percent), retailing (about 60 percent); construction, repair services, restaurants, and transport services (about 11 percent). Men usually engage in metal work, carpentry, brick and block making, maintenance and repair, and women in knitting and sewing, fruits and vegetable sales, food preparation and sale of garments. In 2000, about 30 percent of the MSEs in urban areas and less than 20 percent in rural areas had an annual turnover in excess of M120,000; the bulk in rural areas had a turnover of less than Ml0,000. Entrepreneurial and technical skills in MSEs are low and linkages with the larger manufacturing organizations are generally absent, except for some larger service organizations. 129. As in other countries, MSEs are established and managed without much assistance from the formal sector. As noted in the GTZ survey, only about 6 percent of them are able to borrow from formal institutions. Commercial banks offer credit only to established borrowers and do not readily assist MSEs given poor repayment records. Weaknesses in the legal system including, for example, legislation such as the "received" law of prescription, which stipulates that a loan not recovered within 7 years may not be recovered through legal processes, further contributes to strengthening the culture of non repayment. In addition, there are no second tier banking institutions that mobilize domestic savings and make credit available to MSMEs. 21 Kingdom of Lesotho, "White Paper on a National Strategy for the Development and Promotion of the Small Business Sector in Lesotho.' Maseru: Ministry of Industries, Trade and Marketing. The Government of Lesotho. (Draft). 22 Deutsche Gesellscelaft FurTechnische Zusammenarbeit (GTZ). GMBH, "Promotion of Micro and Small Enterprises in Lesotho". September 2000. 39 B. FINANCIAL SERVICES FOR MSMEs IN LESOTHO 130. A review of the microfinance institutions and programs operating in Lesotho illustrates that the Basotho have fallen behind other African countries in providing financial services to poor, productive microenterprises. The last four decades have witnessed a growing number of international institutions that successfully provide financial services in developing countries to enable poor entrepreneurs to finance investments in business activities, rely on self-employment when wage employment in the formal sector of the economy is limited, fund lump sum requirements, minimize exposure to sudden income changes, and smooth consumption expenditures. 131. Ground-breaking initiatives were pioneered by the Grameen Bank in Bangladesh in the 1970s when it began by focusing on poor women, who organized themselves into groups and guaranteed each others' loans. Their successes continue to inspire others in Africa like the Foundation for International Community Assistance in Malawi, Centenary Rural Development Bank in Uganda, and the Kenya Rural Enterprise Program. These organizations report major accomplishments in reaching thousands (and are trying to emulate their Asian peers who reach millions) through a variety of products and services. Financial services range broadly from savings, loans, payment services, money transfers, and insurance through village banks, credit unions, self-help groups, or a rural financial system. Their performances serve to illustrate a paradigm shift that recognizes that the poor have the capacity to save, utilize credit productively, and repay loans extended at non- subsidized interest rates. Successes have been attributed to the adoption of core principles that are based on commercial practices, streamlined operations, incentives for timely loan repayments, and financial sustainability (see Box 1). In Lesotho, the microfinance sector Basotho has yet to internalize these microfinance best practices. Box 1: Principles that Lead to Successful Microfinance Programs Commercial Practices. Dernand-driven financial services are provided at prices clients are willing to pay for continued access to these services. Credit services translate to short-term loans with amortization schedules that are well-matched to the business and income pattems of micro entrepreneurs. Savings services provide safety and liquidity at low transaction costs. Streamlined Operations. Quality services are delivered on time, efficiently and cost-effectively to clients of MFIs. Simplified and standardized procedures support decentralized operations conducted in modest and welcoming outlets to poor clients. Local community leaders and members play an important, supportive role in the MFI's credit administration process. Incentivesfor Timely Loan Repayments. Clients are motivated to repay on time through repeat loans often in increasing sizes, partial interest refunds based on a perfect repayment record; penalties and financial disincentives including compulsory savings, mutual guarantee group systems to provide peer pressure and installment payments. Financial Sustainability. MFI programs attempt to cover all their operational and financial costs through scaling up their outreach and maintaining a high quality and performing loan portfolio. 132. Following the LADB liquidation and the termination of savings services by the Post Office, the provision of financial services by the formal financial institutions can currently be characterized as unresponsive to the needs of poor and rural MSMEs. Minimum deposit requirements are unattainable with the private sector unable to deposit savings in a secure and remunerative way, savings behavior is not stimulated. Credit services are also 40 unfavorable and inaccessible. The three commercial banks provide almost no finance for the development of MSMEs. Their services have been limited to overdraft facilities to large customers, mostly in the service and trade sectors, and in a few cases to some industrial clients who have established a banking relationship with them over time. These banks have refrained from any involvement in term lending specifically to MSMEs. Their lending approach has been traditionally conservative and based on the need for clients to provide substantial collateral to secure loans against default. In the absence of required collateral in the preferred form (land, property, etc.) and with high transaction costs, credit to MSMEs from commercial banks continues to be minimal. Standard/Lesotho Bank indicates it has made loans as small as Maloti 2000 and has expressed an interest in expanding its outreach to MSMEs but, in practice, continues to maintain an arms length relationship with MSMEs. 133. There seems to be no evidence of a successful microfinance program in Lesotho. Recent studies23 find the micro finance sector is small, unorganized, and lacks reliable data to support any developmental progress. Micro lending is still experimental in nature and microfinance services, largely available through government and donor-supported programs, are generally supply driven and evolving very slowly. In 2000, a report prepared for the Government24 noted that there were about 10 microfinance programs extending services to about 26,000 clients; approximately 500,000 small and micro enterprises had to resort to the informal sector for financial services. Operators still require a better understanding of microfinance institutional and financial sustainability concepts and their operational implications. Programs are centralized, not founded on high levels of community ownership, and generally targeted at the same set of clients, i.e., salaried employees or enterprises dependent on Government contracts. Management information systems lack sufficient data to demonstrate progress toward meeting internationally accepted performance standards governing outreach and sustainability. 134. Factors contributing to this picture are: (i) poorly designed microfinance programs (for example, relatively unsuccessful groups were formed for credit extension and collection purposes as compared to very successful experiences elsewhere in the world where borrowers are both very well acquainted and mutually dependent and responsible for servicing each other's loans); (ii) subsidized credit; (iii) interest rate restrictions; (iv) approaches that allow recipients to treat loans as gifts; and (iv) donors' greater orientation toward disbursements than toward screening borrowers, monitoring project performance, and obtaining loan repayments. 135. The Government, as the primary provider of support to MSMEs, continues to espouse that small businesses need preferential treatment. Lenders themselves are unwilling to take harsh measures toward delinquent clients and borrowers remain willing defaulters. Without strong repayment incentives and social enforcement mechanisms, programs failed and support to MSMEs continues to require injection of subsidized funding. 23 Sustainable Microfinance Development in Lesotho - Addressing Post-Conflict and Long-Term Concerns in Microenterprise Finance, International Capital Corporation, March 1999; Access to Financial Services in Lesotho, Genesis Analytics, July 2002 24 Building Microfinance in Lesotho: Defining Actions by Stakeholders (action agenda based on the deliberations and recommendations of participants at the workshop on microfinance held in Maseru, 22-23 November 2000), International Capital Corporation, 2000 41 136. As the gap between the demand and supply of sustainable microfinance services persists, small private operators continue to spring up in attempts to fill the void. While the core microfinance principles are yet to be fully incorporated into programs trying to reach MSMEs, they could form the seedbed for future rural and microfinance development in the country. Clearly, the growth and development of the sector rests on development and funding strategies that rely on the application of internationally accepted performance- based institution building standards. 137. There are a variety of institutional types that provide savings and credit services to MSMEs but data as to their outreach, financial performance, and sustainability levels is insufficient. The major player, the Government, sponsors credit programs implemented by the Central Bank of Lesotho (CBL), the Ministry of Industry, Trade, and Marketing, the Basotho Enterprise Development Corporation (BEDCO), and the Post Office. Private providers of financial services include multi-purpose and savings and credit cooperatives, money lenders, non-governmental organizations, donors, and the informal sector which consists primarily of rotating savings and credit associations and burial societies. Following is a summary of the microfinance activities in Lesotho. 138. Government-Sponsored Programs. The Government, with support from donors, has been actively trying to fill the vacuum for credit services to Basotho-owned MSMEs in the urban, peri-urban and rural areas. 139. The funded Industrial and Agro-Industries Project: Under this Project, about $1.1 million was disbursed to refinance 12 projects of the Lesotho Bank at an interest rate of 22 percent (5 percentage points above the prime rate), of which 7 percent covered administrative costs and the currency exchange risk borne by CBL. While these rates were in line with prevailing domestic market rates and positive in real terms, the participating bank felt it did not sufficiently compensate for risks assessed by the bank. When the project closed, Lesotho Bank experienced a high percentage of non-performing loans. 140. Microfinance (Reconstruction Fund) Scheme: This scheme was developed and managed by BEDCO following the civil unrest of September 1998. A total of 276 business enterprises from six districts received loans amounting to about Maloti 4.8 million. Only 50 enterprises settled debts totaling about Maloti 0.9 million. The outreach performance under this program is typical of Government-financed programs. Loan repayment rates have been low for reasons including loan cycles that did not match cash flows, long loan maturities that covered several cycles so that when installments were due, funds had disappeared or institutional relationships had deteriorated to a point where borrowers did not feel the responsibility or see the advantage of repaying. BEDCO has decided to curtail lending under this scheme. 141. Rural Finance and Enterprise Support Project: Under an IFAD-funded project, assistance was extended for the formation of groups to enable them to save and borrow among themselves and eventually access resources from banks. There were 133 groups formed of which 60 were registered under the Societies Act of 1966, with a total membership of 1,472. Members lent their savings (amounting to approximately Maloti 588,000, including interest earnings) to each other on a rotating basis at rates ranging from 10 percent to 25 percent per month. Loan sizes ranged from Maloti 50 to Maloti 1,500 with maturity periods up to one year. Monitoring loan repayment performance was not done on a regular basis although information was available and repayment was said to be high. In 42 spite of a Government-financed credit guarantee scheme available under this project, linkages between the banks and the groups in rural areas did not materialize. CBL intends to continue supporting this program through its Rural Savings and Credit Program now that the IFAD-funded project is completed. 142. CBL new programs: CBL is revising three guarantee programs that are still on the drawing board to increase the level of lending provided by the commercial banks to small and medium scale businesses and exporters,: (i) The Export Finance and Insurance Scheme and (ii) the Rural Savings and Credit Program (which aims to further the objectives of the completed IFAD-funded Rural Finance and Enterprise Support Project); and (iii) a Development Finance Project targeted at SMEs. The banks view this facility as attractive and are optimistic that they will utilize it fairly extensively in their future operations. However, as designed, it is our view that these programs are not likely to be implemented successfully. 143. Under these programs, participating banks can apply for guarantee coverage on loans they extend to qualifying businesses under certain constraining conditions including maximum loan size, loan term, interest rates, and loan purpose. The banks analyze and approve all credit applications under these guarantee schemes using their own internal lending criteria, although each fund does review the guarantee applications and can reject coverage if the established conditions are not met. 144. Export Credit Finance Guarantee Scheme: The Export Credit Finance Guarantee Scheme, managed by the Central Bank was established in 1988 to meet the short term pre- shipment and post-shipment financing requirements of exporters and enterprises not previously supported by commercial banks. Guarantees were extended up to a maximum of 85 percent of the total loan amount. At its peak of operation in 1994, the loan portfolio under this program amounted to approximately Maloti 40.4 million. About 31 percent of exporters benefited from the scheme; 67 percent of the loans were extended to large enterprises that were engaged in the electronics industry. Implementation of the scheme collapsed as a result of high non-repayment rates. The incentive on the part of participating banks to enforce their collection policy and on the part of borrowers to service their loans was inadequate because of the high percentage guaranteed. 145. CBL is revising the Export Credit Finance Guarantee Scheme under a new Export Finance and Insurance Scheme. As designed, the new scheme would assist SMEs (which would receive 60 percent of the funding) and large enterprises with links to SMEs (40 percent). The credit facility would be limited to Maloti 1 million for beneficiary SMEs and Maloti 5 million for large exporters. A guarantee cover would be provided by CBL. There is also a maximum interest rate which can be charged by the banks under this program which is the prime rate -17 percent as of December 2002. A guarantee premium, of 0.75 percent, and an application fee of 1 percent would be charged by the guarantee fund. While there may be a role for this export credit program within the Lesotho's financial sector, the performance under the new scheme may not be different from that under the old scheme without changes in the design in light of the relatively poor response from the commercial banking sector in the old scheme, the lack of recent growth in fund usage, and the ongoing desire to make this program available mainly to the low end of the market. 146. The Rural Saving and Credit Program. Under the Rural Savings and Credit Program, Government and donors would fund the scheme and informal groups will be the 43 target beneficiaries (they will have to be formally registered to access credit from commercial banks). Linkages between the groups and commercial banks would be encouraged through the proposed provision of a guarantee scheme that would cover 50 percent of the credit risk. As designed, the interest rate would be capped at the prime rate which does not allow the financial institutions to fully cover their credit risk exposure and transactions costs. The CBL is also expected to play a major role in the implementation of the scheme, which is contrary to best practices in microfinance which rely on local, group leadership and control. As designed, this program is supply driven and does not encourage the development of a market driven, indigenous sector-led, and sustainable approach to microfinance services. It continues to reflect the unwillingness to accept the paradigm shift in microfinance that recognizes poor people save, borrow for productive purposes at market interest rates, and repay their loans because they value reliable access to financial services. As funding for this project remains unclear, it is not yet being implemented. 147. The Development Finance Project. Under the proposed Development Finance Project, approximately Maloti 26 million is planned to be made available (from the proceeds of the Government's privatization program) through commercial banks to finance short and long-term (1-10 years) credit requirements of Basotho-owned enterprises. Loan applicants will have an equity participation requirement of 10 percent plus a minimum security coverage of 70 percent. Maximum loan size per client would be limited to Maloti 1.5 million or 5 percent of the total loan fund. The prime rate would be the basis for the interest rate. In addition to the assessments and approvals made by participating banks, a steering committee comprising stakeholders from a number of government agencies, will also be charged with approving projects. While the project is still being designed, as with the other above-described projects, two factors which will lead to less than successful results are the close involvement of the Government and CBL in credit appraisal, approval and supervision and the capped interest rates. 148. The mission recommends that CBL continue with these guarantee operations over the intermediate term given the virtual absence of MFI lending institutions and programs, the inability of LNDC and BEDCO to lend in a satisfactory manner, and highly conservative bank lending strategies providing they are appropriately redesigned. It is imperative that all interest rate limitations be removed from these programs to increase the incentives for participating banks to utilize the facilities and to ensure that they do not undermine the development of unguaranteed MFI initiatives which would need to lend at substantially higher interest rates than the present caps in these programs to have any chance to operate on a financially viable basis. Commercial banks are not likely to use the facilities extensively if there are interest caps as the guarantees do not (and should not) cover their entire credit risk exposure and higher than normal administrative and transaction costs are involved in this type of lending. The fund requirements should also be reviewed as they presume that borrowers have an account relationship with a commercial bank, operates proper accounts, and possesses a level of fixed assets or inventory (which may not be available) over which the bank can place a lien for at least its 50 percent credit exposure. 149. The Postal Financial Services. The Post Office extends credit services to civil servants. In 2000 and 2001, an average of less than 4,000 loans were granted for a total of approximately Maloti 6.5 million; reliable data on the quality of the loan portfolio and 44 repayment performance is not available. Other products and services extended by the Post Office during this period25 include: Table 17. Lesotho Post Financial Services Product Average, 2000, 2001 Number Paid Amount Paid Domestic money orders 6,700 1,890,000 International money orders 23,800 8,770,000 Domestic postal orders 27,000 790,000 Intemational postal orders 4,300 1,350,000 Pension payments 1,400 910,000 Bill payments, 2001 115 1,103,700 Source: Net Post Consultancy (2002) 150. Currently, the Government is considering the re-establishment of financial services for the public to be provided by the Post Office in urban, peri-urban and rural areas. There are 47 post offices (35 in rural areas) and 105 post agencies (with the majority in rural areas). As designed by technical advisers to the Government, it is envisaged that the Lesotho Postbank (LPB) would provide a full package of retail banking services (savings, payment, micro credit, other financial services) over time including: (i) standard financial products (savings pass book, savings certificates); (ii) account-based payment products, based on salary and pension payments from government institutions and enterprises to giro accounts of private customers; and (iii) dedicated financial products (micro credit). Based on cooperation between Lesotho Post (LP) and the LPB, development of the LPB would be in phases with services to be initially introduced in 10 pilot areas and technical and/or management to be provided through a partnership between the Government, selected banking or financial institutions, and an international post bank. LPB will be governed by the Postal Law and regulated by CBL. 151. Risks associated with the proposed LPB are high and achieving viability would be difficult even if its objectives were primarily commercial. Most postal banks in Africa have serious operational and control problems and have been performing poorly financially. 152. Therefore, it is essential that the Government be guided primarily by the need for the bank to be profitable. Unfortunately, the Government's blue print highlights that "The Government has a social obligation to open the branches of a LP in certain areas where it may not be profitable at all hence the reason for Government's greater involvement during the initial days of operation of the LPB." Moreover, the evaluation criteria in the business case summarizes the objectives as "a balance between sustainability and social benefits". This ambiguity in objectives may make the envisaged public-private partnership difficult to achieve if Government is focusing on the social benefits and the private partners focus on profitability. It is important to understand that social benefits will flow only if the bank can be re-established on a profitable basis. Also, if this project does go ahead, it is recommended that the bank not be re-established before the private shareholders and the technical partner have been identified, a comprehensive business plan and modus operandi have been developed, and the overall implementation arrangements agreed upon. 25 Fact Finding Phase, Re-establishment Project, Post Offices Savings Bank Lesotho, NethPost Consultancy, 2002 45 153. We are concerned about the ideas expressed that (i) the re-establishment of the bank be piloted by a Project Management Council composed of Government employees; and (ii) 11 key positions, including the Chief Executive Officer, be filled by candidates from the Lesotho Post (LP). These recommendations should be reviewed given LP is not a financial institution and government employees generally do not have the financial and business skills to handle savings and credit requirements of private entrepreneurs. Finally, we wonder whether the plan is realistic and the projections overly ambitious. For example, while the projections appear to be comprehensive, they are for the entire re-established entity so the banking business is not easy to evaluate. It would thus be helpful to have a sensitivity analysis of the principal assumptions. Also, the consultants identified a number of critical success factors and indicated that these conditions have not been completely fulfilled, possibly causing delays. 154. Most postal banks in Africa have serious operational and control problems and have performed poorly financially. It is, therefore, recommended that the LBP not be reestablished unless i) all control problems relating to accounting for deposits are solved; (ii) it operates only in locations for which anticipated volume of business will allow breakeven financial performance within a period of two years; and (iii) it is not allowed to make loans. 155. Deposits could be used to invest in CBL guarantee schemes, T-bills, and longer- term bank deposits. Also, if this project does go ahead, it is recommended that the bank not be re-established before the private shareholders and the technical partner have been identified, a comprehensive business plan and modus operandi have been developed, and the overall implementation arrangements agreed upon. 156. Cooperatives and Credit Unions. Cooperatives and credit unions were established primarily to support a variety of requirements of their members for productive purposes, including savings and credit services. Reports on the performance of cooperatives and credit unions suggest that some are collapsing or on the verge of collapsing while others continue to operate despite serious weaknesses. An International Labor Organization report,26 documents the fact that over a twenty-year period, from 1971 through 1991, credit unions spread widely in rural communities and exhibited the potential to effectively respond to their members' financial requirements. However, by the end of this period, weaknesses in their management and credit administration led to financial problems. Lending policies were conservative and restrictive with loan amounts limited to a member's share savings. These limitations plus other factors, including members' insufficient savings and choices not to honor debt obligations, led to high loan delinquency rates and the contraction in real terms of credit unions' key performance indicators (number of members, assets, savings, etc.). Also, interest rates did not cover lending costs or allow for adequate compensation for savings. 157. After 1991, when donors decided to focus on agriculture to assist the poor and agricultural credit banks could not be considered as effective alternatives to administer their credit lines, credit unions were targeted to support agricultural production in rural 26 Morris, K.J., "The Effect of Using Credit Unions as Lending Agents for External Lines of Credit: The Experience of the International Credit Union Movement," International Labor Organization, Geneva, Switzerland, 1995 46 areas despite the policy and management problems they faced. Although considerable resources from donors were provided to build their technical and financial capacity, credit unions and federation leaders and managers continued to resist adopting rigorous management policies to avoid displeasing their members and to serve their own interests. With the continued availability of loan capital, credit union leaders and managers were shielded from their responsibilities to maintain safe, sound and sustainable institutions. Advice, guidance, and financial assistance remained ineffective in the absence of harmonized and integrated interests by donors and credit unions. In 1988, only 16 of 63 credit unions were considered to be operating at acceptable levels. Unverifiable information provided in the country indicate that there were about 83 credit unions in Lesotho by 1992 and about 131 a decade later in 2002. 158. In addition to the credit unions, cooperatives also provide financial services. While there are over 1,000 cooperatives, information from the Commission of Cooperatives was not available as to the number of cooperatives established primarily as savings and credit cooperatives and on those established as multi-purpose cooperatives offering savings and credit services as one of their activities. Accurate information on their outreach and financial services was also not available although anecdotal evidence suggests that some cooperatives have about 10,000 members, lend from Maloti 200 to Maloti 10,000 to any one borrower, and achieve repayment rates of about 85 percent. Credit experiences of cooperatives are said to be comparatively better than other institutions because of group discipline, peer pressure and shared interest within the cooperatives. 159. Money Lenders. Money lenders, including individuals or groups of individuals, generally lend out small amounts to civil servants, employees of government agencies, and construction contractors. Their outreach ranges in number from a few hundred to about 3,000 Basotho. Like cooperatives, loan sizes generally vary from Maloti 200 to Maloti 10,000 with few clients able to access over Maloti 100,000, maturity periods vary from 1 to 15 months, and repayment rates vary from 50 to over 95 percent. Credit obligations are covered by payroll stop-order agreements or tripartite agreements between the government and contractors. Although money lenders often rely on an underlying fee arrangement with a third party in the payroll or personnel unit of a government institution to ascertain the payroll deduction or serve as a collection agent, collection can still be unreliable. Some borrowers manage to intercept their paychecks or get payroll data on their loans changed. Reliable data are not available to support claims of money lenders as to their repayment rates, loan classification, or loss provisioning practices. 160. There are about 25 money lenders registered with CBL, of which 10 meet CBL reporting requirements. CBL regulates money lenders and has imposed a maximum lending rate of 25 percent per annum on them, a rate which money lenders see as unrealistic, and which does not allow them to cover their costs and make a profit. Compliance with CBL money lender requirements is not uniform. Money lenders are constrained by their limited funding resources, high transaction costs, high tax rates (45 percent of taxable income) weak institutional capacity to expand their outreach and increase collection rates, risk averseness, and lack of creativity in product development. Some illegal money lenders impose extremely unfavourable lending conditions on their customers. 161. Donor-Funded Programs and NGOs. Donor-funded programs dominated the micro finance sector for several decades. In addition to support for credit unions, other donor projects designed to support the Government's objective of increasing enterprises' 47 income generating activities and developing the microfinance sector were channeled through NGOs and accomplished little in terms of outreach, institutional development and financial sustainability. Willful default prevailed as borrowers entertained feelings of entitlement particularly when they perceived loans were extended by the Government or Government-controlled institutions, originated from obviously wealthy sources, or were provided for political reasons. When joint liability features were adopted in granting loans, mutual guarantee and peer pressure features of the solidarity group failed particularly when access to credit was the motivating force for forming groups. NGOs were insufficiently prepared to handle credit responsibilities and decentralized governance procedures. In addition, they were often unwilling to take harsh measures toward delinquent clients particularly when motivated by charitable and disbursement objectives. Little emphasis was placed on effective credit delivery, enforcement of loan terms and guarantee mechanisms, and diversity of financial products. As a result, the rural and micro finance sector continues to flounder and remains dependent on repeated injection of funds for operational costs and subsidized lending despite decades of support by donors. 162. The NGO Credit Center was established in 1997 to facilitate access by NGOs to a credit guarantee facility with the Lesotho Bank funded by the United Nations' Children's Development Fund. Other donors including the African Development Foundation, Irish Aid, UNDP, and UNIDO also participated in this project. Three NGOs, the Women in Business, Lesotho Chamber of Commerce and Industry, and Lesotho Council of NGOs, utilized the facility. However, results were unsatisfactory because of the failure of Lesotho Bank and because the NGOs were unable to effectively implement sound credit policies. By end-October 1999, a total of 117 clients received loans amounting to Maloti 505,550, an average loan size of about Maloti 4,000. 163. An evaluation report27 on the project in January 2000, documented the recovery rate at 76% for the Lesotho Chamber of Commerce, 62% for Women in Business, and 62% for the Lesotho Council of NGOs. It is difficult to draw lessons from the experiences of these NGOs as the project was poorly designed, management accounts were not kept, accounting for funds from different donors was not closely followed, operating costs were very high (about two and a half times revenue), and credit policies and procedures characteristic of successful microfinance institutions worldwide were not followed. Thus these NGOs' support for micro enterprises has been dwindling increasingly as the size of the recycled funds decreases with low repayments and high administrative costs. Also, donors have been reluctant to increase their assistance to this initiative in view of the poor performance. 164. Informal Financial Organizations. Informal sector organizations in the form of rotating savings and credit associations (ROSCAs) are prevalent in the country. Members of these associations, the more common ones being stokeveles and Christmas savings clubs, meet every month, regularly contribute a certain amount of money, and either on a rotating basis or based on a member's need, provide loans to members enabling them to access financial resources earlier than if they had saved individually. Interest on loans may or may not be levied and peer pressure minimizes defaults. Another source of infonnal finance is the burial societies, which exist for people in a village or neighborhood who try 27 Olney, Gavin and Bohloa, Tseko A., The NGO Credit Center, Lesotho Chamber of Commerce and Industry, Women in Business, Lesotho Council of NGOs - Final Evaluation Report, Joint Management Committee, January 2000 48 to insure themselves against high burial costs through payments of monthly premiums. These societies pay out when a member or a member's relative dies and also lend out funds accumulated from premiums. While ROSCAs and burial societies are not regulated and no data are available on them, anecdotal information indicates that their credit experience is very good with nearly 100 percent repayment performance for loans. C. THE REGULATORY AND BUSINESS ENVIRONMENT 165. Several laws affect the rural and microfinance sector in Lesotho. Institutions with a microfinance development agenda can register under the Financial Institutions Act 1999, the Companies Act of 1967, the Associations Act, the Societies Act of 1966, the Cooperative Societies Act 2000 or the Money Lenders Act of 1989. In reviewing these laws, it can be concluded that the legal and regulatory environment and financial policies in Lesotho are outdated and provide an unfriendly environment for the development of indigenous responses to the financial requirements of MSMEs. As illustrated below, these laws discourage responses to MSMEs by the formal banking sector, non-governmental organizations, or Basotho-operated micro finance institutions. It is essential that an examination of the banking, financial, and organizational requirements that govern these institutions and the business enabling environment be conducted and modifications made to existing laws to enable rural and micro finance institutions to develop and increase their responsiveness to the financial needs of the productive poor in urban and rural areas. 166. CBL regulates and supervises the activities of banks and financial institutions and processes applications for licensing and registering banks and financial institutions as stipulated in the Central Bank of Lesotho Act of 2000. Serving as the Commissioner of Financial Institutions, it also implements the laws that govern banking and finance activities as set out in the Financial Institutions Act of 1999 and the Money Lenders Act of 1989 and is responsible for setting limits on the licenses of banks and financial institutions including those relating to types of deposit resources that may be mobilized from the general public and the financial services that may be offered by these institutions. MFIs' establishment and operations are affected by provisions in the Financial Institutions Act of 1999 that cover the definitions of a bank and the business of banking and deposit-taking; business activities permitted for licensed banks and financial institutions; and the prescribed procedures, standards and criteria for licensing, regulation and supervision of banking and financial institutions by CBL. Money lenders are regulated under the Money Lenders Act of 1989 and Cooperatives under the Cooperatives Societies Act 2000 which regulates savings and credit activities and place of operations, etc. 167. The Financial Institutions Act 1999 and the Cooperatives Societies Act 2000 stipulate that only companies incorporated or registered under Lesotho law may operate as financial institutions lcan collect deposits. However, while cooperatives are not allowed to collect savings from non-members, some cooperatives' services and membership requirements are sufficiently attractive to encourage a large number of the unserved public to sign up and bank with them. For example, membership fees are as small as Maloti 50. It is clear that the provisions in the Cooperatives Societies Act 2000 and the associated regulations do not sufficiently protect the financial system as a whole nor the safety of small deposits of individual institutions and depositors. Lending and investment restrictions on cooperatives are few and many support a variety of subsidiary organizations, many of which become money-losing ventures. 49 168. Also, the Commission of Cooperatives, now under the Ministry of Industry, Trade and Marketing, which is mandated to supervise all cooperatives including those whose by- laws permit deposit taking from members and non-members leading to the collection of substantial savings essentially from the public, is neither technically prepared for the prudential and supervision responsibilities over larger deposit-taking cooperatives nor equipped to carry out on-site or off-site inspections regularly. While there are reporting requirements on cooperatives' financial activities including the requirement to submit annual audited financial statements, compliance by cooperatives is periodic and the quality is suspect. It is recommended that all cooperatives with deposits and/or a number of depositors above a specified size should be subject to CBL regulation and supervision in addition to the cooperative regulations. 169. In Lesotho, money lenders, who are not allowed to collect savings from the public, are regulated by CBL. Driving this is CBL's interest in utilizing quantitative information they are supposed to obtain from money lenders to formulate, implement, and monitor financial and economic policy, conduct macroeconomic analysis and research, and monitor money lenders' compliance with laws and regulations affecting their operations. While CBL recently issued a new standard reporting format to be followed by money lenders that includes audited financial statements and schedules on loans and other investments, compliance by money lenders has not been uniform. Also, CBL is able to monitor the financial operations of these money lender only periodically. Moreover, it is likely that CBL-imposed restrictions on money lenders which impose a maximum 7 percent margin above the prime rate, i.e., a rate of about 25 percent at present, in all probability, significantly reduce the amount of loans money lenders are willing to make available since few of them have access to significant borrowed funds at much less at prime rates. Thus, while regulating money lenders who do not collect savings does little to protect the financial system and may reduce access to credit somewhat, it is also ineffective in monitoring money lenders and obtaining reliable data on them. 170. As money lenders do not take deposits from the public, it is unclear as to whether the benefits associated with CBL supervision of money lenders exceed the disadvantages and the decision as to whether or not CBL should continue to supervise money lenders should be reviewed. 171. The regulatory barriers that affect an MFI's entry into the financial sector include provisions in the above mentioned laws relate to minimum capital levels, geographical restrictions, limits on the range of activities and services, protective controls (through interest rate ceilings), and reporting requirements. A ten million Maloti minimum capital requirement (about US$1.25 million) is one of the more restrictive barriers for MFIs to enter the financial sector. A review of this requirement in light of other country experience and practice could guide in setting a feasible capital requirement level for MFIs in Lesotho since there are no international capital standards for MFIs. Another regulation adversely affecting MFIs is classification and provisioning requirements for unsecured loans which do not allow banks to rely on guarantees from individuals and on joint liability groups (the most common collateral for much MFI lending) as acceptable collateral leading to a need for highly conservative provisioning on much MFI lending which makes this lending less profitable. 50 172. Interest rate restrictions for financial institutions have been removed in most cases; unfortunately, other government funded programs and money lenders are not included in the interest rate liberalization policies. Additionally, outreach in difficult areas is hampered by CBL's application requirements to establish a new branch or office, the requirement to demonstrate the need for banking and financial services in the community and related profitability and physical security aspects of the proposals, and regulations on branch locations, hours of operation, and standards for staffing of branches and offices. 173. It is important that Lesotho's legal and regulatory framework for financial institutions is reviewed and modified so indigenous-based services and instruments can be developed and mature to better support linkages with the formal sector. A careful assessment of the different kinds of institutions and the nature of their activities, scale and funding sources should be undertaken to provide a basis for defining a MFI regulatory and supervisory framework. In analyzing whether and how to supervise and regulate MFIs, authorities ought to be guided by best practice which recognizes that the threshold for prudential regulatory intervention is crossed when an MFI begins to mobilize savings from the general public. Different forms of supervision, including self-monitoring through a peer organization, should be explored to promote the development of institutions which do not fall under the supervision of CBL. 174. It is also important to correct the country's current financial policies that support the persistent provision by the Government of directed, subsidized credit programs. The Government's presence not only crowds out private-based initiatives but adversely affects the commercial operations of indigenous MFIs, distorts markets responsive to MSMEs, and erodes the flow of funds to those least able to access financial services. 175. The provision of financial services for MSMEs by banks and indigenous institutions has been negatively affected by weak contract enforcement capacity and practices. Although a commercial court was established in 2000, legal practitioners acknowledge an effective commercial court will require the court's lawyers to obtain additional training and that the legal information system and Government registries will need to be updated and computerized to facilitate access and retrieval of information. In the absence of efficient, reliable, computerized registration systems, verifying the existence of a business, liens and other security interest placed by creditors on both immovable and movable property of borrowers is a slow, tedious and expensive process. Settlement of debt obligations has been delayed as debtors and defendants abuse the system and exploit opportunities which exist to reduce the effectiveness of the enforcement mechanisms. Weaknesses in the legal framework also make it difficult to develop credit information systems that would benefit not only the financial sector but also the commercial sector. Information obtained from an automated central registry system with satellite outlets in commercial centers, together with that from an established credit reference facility, could reduce the risks of lenders and the cost of credit and financial transactions for enterprises. In addition, the effective exchange of credit information among institutions could lead to the commercialization of MFIs and the development of effective linkages between MFIs and the formal sector. 176. Currently, formal or customary law set limits on the property rights of women (in spite of the preponderance of women-owned micro-enterprises). A review and modifications to relevant laws should be implemented to enable women to maximize their contribution to economic activities. 51 D. DEVELOPMENTAL RECOMMENDATIONS 177. The Government is aware of the need to provide an enabling environment for rural and microfinance institutions to thrive as economic agents in urban and rural areas. Small private operators have sprung up in attempts to respond to the gap between the demand and supply of rural and microfinance services. The Government is clearly aware of past failures, has taken initial steps for it and other stakeholders to be fully aware of best rural and microfinance practices, and wishes to incorporate principles of sustainable rural and microfinance services and lessons learned from past experiences in the design of their future programs. 178. However, donors face limitations in the resources available for the development of the financial sector and are interested in supporting programs that can demonstrate successful assistance to the poor that translate to reduced poverty and improved living conditions on a sustained basis. Also, while a significant amount of cash and liquidity appears to exist outside the formal financial system and in rural areas, the closure of branches and offices in the rural areas by established banking institutions and the Post Office has made the accumulation of savings deposits and the intermediation of resources more costly and difficult. These conditions could form the seedbed for future rural and microfinance development in the country even if the core microfinance principles are yet to be fully incorporated into existing programs trying to reach MSMEs. 179. The ability of institutions to meet the challenge of providing sustainable financial services to large numbers of poorer enterprises is largely based on their ability to adhere to the following basic principles of rural and micro finance: (i) financial services are demand-driven and provided at prices clients are willing to pay for continued access to these services; (ii) quality services are delivered on time, efficiently and cost-effectively to clients; (iii) incentives motivate clients to meet their debt obligations on time; and (iv) MFI programs cover all their operational and financial costs by operating efficiently, scaling up their outreach, and maintaining a high quality and performing loan portfolio. 180. For financial institutions, this would mean that savings services need to respond to clients need for convenience (access to savings services without taking too much time away from their businesses), liquidity (clients' access to their savings when they need it), and security (clients are sure their savings are safe and the institution that collects them is stable). Credit services will have to be extended by institutions that utilize character-based lending methodologies and emphasize continued access to credit based on a good track record of loan repayment. Loans should be granted based on the applicant's character, ability and willingness to repay, and guarantee mechanisms should utilize peer pressure to obtain repayment and provide incentives for timely loan settlements (including the benefits of larger, longer-term, repeat loans, and sometimes even a partial refund of interest payments). Interest rates cover the high costs of delivering services efficiently in difficult and remote areas and the risk of lending to a large number of poor entrepreneurs with viable and productive projects but whose borrowings are small and often not backed by collateral. Business policies must, first, reflect a strong sense of mission and vision directed at assisting the poor and, second, require that the financial institutions are 52 independent and free from political interference, accountable to their clients who also participate in the governance structure, and operate based on sound financial and management information systems. 181. Clients will recognize and support effective institutions (through higher interest payments and timely loan repayments) to be able to quickly access convenient services and loans that suit their own business conditions. Clearly, the growth and development of the sector rests on developing and implementing funding strategies that rely on the application of internationally accepted, performance-based institution building standards. To reach there, the following action steps are recommended. 182. Develop and implement a learning program to disseminate information on rural and microfinance good practices. A well-defined and effectively implemented learning program, needs to be made available to managers and operators of rural and microfinance programs, money lenders, savings and credit cooperatives, commercial banks, CBL, and Government ministries and agencies, to provide information on financial system building strategies that have been successful at reaching the poor and productive MSMEs over the past decades. Exposure to successful programs in the Africa region and internationally would enable all stakeholders to acquire technical support and training to improve operational performance, product design and market orientation. It is recommended that training be made available to organizations that have demonstrated a willingness to adopt state-of-the-art knowledge and practices for the sustainable provision of financial services through competitive and performance based processes. It is also important that the learning agenda be provided through affiliations with technical partners and successful microfinance institutions and networks regionally and internationally. 183. Reinforce the leadership and partnership roles of microfinance stakeholders in the development of the microfinance sector. This action step will support the formalization by the Governiment of a consultative process between public and private microfinance stakeholders to provide the right environment for developing sustainable rural and microfinance services. Opportunities for greater dialogue with government should be supported to positively influence the development of specific policy issues and strategies that lead to the provision of an enabling environment for the development of a variety of institutions serving low income entrepreneurs. Government agencies including the CBL, Ministry of Finance, Ministry of Industry, Trade, and Marketing, and the Ministry of Agriculture should have access to technical and practical data that would assist them in undertaking policy-making decisions, resolve the role of public versus private rural and microfinance institutions, and remove overlapping functions, responsibilities, missions and product lines that complicate and restrain the sustainable development of the microfinance sector and crowds out the private sector's development initiatives through workshops, meetings, exposure visits, training, etc. 184. It is recommended that this action step lead to the (i) adoption by the Government of a Rural and Microfinance Policy and Development Action Plan; (ii) the resolution of the role of public versus private microfinance institutions; (iii) the rationalization of conflicting product and service design in government-sponsored rural and microfinance programs at both the government and donor levels; (iv) the elimination of political interference and subsidized and/or directed credit; and (v) the selection of an agency charged with the implementation of government policies and the development plan. 53 185. Create a rural and microfinance forum or association to serve as a body that will set standards for rural and microfinance, provide a platform for discussion and information dissemination, and take on an advocacy role with the Government and the CBL. Building on the learning agenda and the formalized consultative process, this rural and microfinance institutions network would seek to: (i) develop performance and reporting standards based on international practices for rural and microfinance service providers; (ii) define incentives for providers to adhere to performance and financial reporting standards; (iii) formulate and implement a code of conduct for microfinance providers; (iv) provide a platform for discussion and information dissemination; (v) establish a professional secretariat in order to exercise the function of self-regulation; (vi) assist regulators in data collection, reporting and monitoring of licensed MFIs; (vii) play an advocacy role for MFIs in the development of an appropriate policies, legal and regulatory structure; (viii) establish partnerships with microfinance networks, financial (donor and commercial) and technical partners locally, regionally and internationally; and (ix) certify practitioners that meet microfinance best practices and performance standards as a necessary pre-condition for the receipt of donor support and make available financial and capacity building sources to fund innovations where opportunities to leverage private capital exists for these rural and microfinance institutions. 186. Support research and development activities, particularly institutional innovations, pilot programs, and development of new products and services. In Lesotho, poor entrepreneurs find it essential to diversify their sources of income to prepare for unforeseen economic and business conditions. Lenders also prefer to lend to households with more diversified asset portfolios and income sources to be better able to cover covariant risk, diversify their assets and liabilities, and increase and stabilize their clients' repayment rates. As the non-price attributes of credit institutions, including the type and range of loans and services provided and the restrictions on their use, generally play a larger role in the selection decisions clients make on financial institutions than the level of interest rates charged on loans, it is important that a wide range of financial products and services are available as this determines the prospects for a financial institution's growth and sustainability. For commercial banks, this would translate into engaging in research on the microfinance market and exploring financial and business partnerships with rural and microfinance institutions. 187. Develop an appropriate legal and regulatory framework for Rural and Micro Finance Institutions. A careful analysis is required to determine whether and how to supervise and regulate MFIs based on the different kinds of institutions and the nature of their activities, scale and funding sources. The threshold for prudential intervention by the CBL in the regulation and supervision of microfinance is crossed when a rural or micro finance institution or cooperative begins to mobilize savings from the general public. Given the small and yet undeveloped sector and the lack of reliable data, it is important that an in- depth financial and institutional analysis be carried out on cooperatives, money lenders, and other micro finance organizations by technical experts to determine the appropriate regulatory framework to be introduced. In addition to reviewing and updating current regulations, establishing a tiered structure for licensing intermediaries and adopting appropriate prudential and non-prudential measures to regulate financial activities should be considered. Other forms of supervision, including self-monitoring through a peer organization, also promote the aim of increasing the quality and transparency of implementing institutions which do not fall under the supervision of CBL. 54 188. As highlighted earlier, the imposition of interest rate caps limits innovation and competition as financial service providers are unable to cover their financial and operational costs and provisions for loan losses. The imposition of interest rate caps, when enforced, almost always hurt the poor through reducing access to credit and services far more than they help the poor by lower rates. It is recommended that interest rate caps and other restrictions (for example, the inability to advertise services or open branches in rural areas) be examined carefully and eliminated to encourage Basotho-led responses to bridge the savings and credit services gap in the rural areas. 189. Update the laws and rules supporting the creation, registration, perfection and execution of security interest in loans and modernize the supporting infrastructure. Currently, the process of registering and conducting due diligence search and verification of secured interests is tedious, inconvenient, expensive, and subject to abuse. These weaknesses negatively affect the cost of credit transactions and the lenders' willingness to take risk thus minimizing access by rural and micro and small scale enterprises to financial services. To rectify this, it is important that outdated laws and regulations are reviewed and updated; procedures rationalized; supporting infrastructure established in principal centers; training requirements of legal practitioners in the commercial court met; and provisions made for technical input to improve the efficiency of public registries through appropriate recording and retrieval of information on pledges made so benefits accrue to the financial and the commercial sectors. 190. Credit bureaus provide important benefits both to financial institutions and their clients. The availability of information on clients' status and history from a range of credit sources allows lenders to lower their risks and borrowers to use their good repayment record as a means to access new credit. Lenders also become more aggressive about lending without physical collateral. Depending on the nature of the database and the conditions of access to it, the availability of reliable and accurate credit information can also have a beneficial effect on competition among financial service providers. It is recommended that appropriate technical support be provided to assist in the development of an appropriate credit bureau. 191. In addition, it is recommended that the review of formal or customary law limiting the property rights of women be carried out promptly. With the preponderance of women- owned micro-enterprises, it is important to legitimize their standing as equal members in society and to substantially support increasing their contribution in economic activities. In so doing, the overwhelming contribution of women to the success of micro and rural finance programs and to economic development worldwide can be replicated in Lesotho. 55 ANNEXES Annex 1: List of Recommendations A. Macroeconomic and Financial policies Monetary policy: The structure of the financial system indicates that there is poor transmission of monetary policy as interest rates (especially deposit rates) do not appear to respond to changes in the stance of monetary policy. Perhaps more importantly from a financial intermediation point of view, banks are more interested in deploying funds into treasury bills, which earn a respectable return with zero risk. There is therefore the danger of significant crowding out as domestic banking credit to the private sector shrinks. Treasury bill auctions and reserve requirement: People interviewed expressed that CBL's participation in the competitive bidding for treasury bills distorts the market and casts doubt on the extent to which T-bill rates are truly market determined. We therefore recommend: (i) That market participants be fully informed of the details of the CBL's participation in the non-competitive bids in order promote transparency. (ii) Redefine the Liquid Assets Requirements to exclude balances lent to local banks. B. Banking Sector: Competition in the banking sector: Inadequate competition is Lesotho's most serious financial sector issue at this juncture and the following actions are recommended to address this issue: (i) Proposed amendments to the Financial Institutions Act 1999 should be drafted to allow for the licensing of nonbank financial institutions under conditions that differ as appropriate from those pertaining to banks including significantly lower minimum capital requirements. Institutions with an "NBFI or Tier Two" license should not be allowed to take demand deposits and other specified deposits from the general public as institutions with smaller capital are likely to be riskier than full commercial banks and to ensure an equal playing field among demand deposit takers. (ii) Consideration should be given to allowing new banks to be licensed to do business with a tier two license and lower minimum capital requirements. Cooperative banks that take deposits from nonmembers, the proposed Postal Bank and possible smaller new domestically owned banks might be candidates for tier two licenses. Cooperative banks that take more than a certain level of deposits from nonmembers should be required to obtain a license from CBL and become subject to its supervision. (iii) A study should be undertaken as to whether or not foreign bank branches should be allowed to operate in Lesotho with a tier two license. This would increase competition in the blue chip corporate niche market, but might do little to increase competition for retail business. (iv) Banks should not be allowed to take advantage of the present monopoly conditions to pay significantly below market rates for savings deposits that are significantly negative in real terms and roughly half that of parallel rates in RSA 56 banks just across the border. They are being subsidized by savers and the low rates drive deposits to South Africa and reduce the incentives to save. Therefore, the CBL should use moral suasion to cause banks to raise deposit rates to the levels prevailing in South Africa and to maintain such rates as a minimum thereafter. Increasing Access to Credit from the Banking System: Lending by private banks will never reach satisfactory levels unless and until the Authorities take aggressive steps to significantly improve the credit disciplinary environment. Lesotho has established a commercial court as an extension to the High Court. Recommendations toward achieving this objective include the following: (i) Take steps necessary to remove all obstacles to effective functioning of the commercial courts including streamlining procedures for registering "bonds" or claims against collateral and providing technical assistance to practitioners on financial sector operations. (ii) Ensure that a credit infornation bureau is functioning effectively. (iii) Establish a system that ensures that each privately owned property has a unique legal address. (iv) Take steps necessary to ensure that the old bad loans of Lesotho Bank and the Agricultural Bank are collected in all cases except where borrowers have no capacity to pay. (v) Amend the clauses in the Matrimonial Act that do not allow married women to act without their husband's or a guardian's signature. C. Non-bank Financial Institutions Insurance sector: The following recommendations relating to the insurance industry should, for the most part, await the findings of the consultants working on the sector under the FIRST initiative: (i) CBL should immediately identify at least one Financial Institutions Department staff member (the consultants may recommend more than one) who will work full time on insurance and be responsible for ensuring that reporting requirements are met and for reporting on the status and condition of the insurance industry. (ii) All insurance companies should be required to adopt the same financial year for reporting purposes. (iii) Insurance companies should be required to file quarterly reports which inter alia provide information on what the investment portfolio consists of, what portion thereof is in Lesotho, and whether or not investments are in compliance with the requirements. (iv) LNIC should be required to provide a detailed annual audited report on the Corporate Bodies Pension Scheme which provides information on its assets, liabilities, investment results, inflows of contributions, payment of benefits, number of participants, etc. Pension scheme funds and operations should be completely separated from those of LNIG in its accounting and, thereafter, LNIG, like its competitors, should be required to pay tax on all of its profit before tax, regardless of source. 57 Pension system: It is recommended that: (i) A study be commissioned on the Lesotho's pension industry and the related laws and regulations and, based on that study, assist in catalyzing the preparation of enabling legislation for the pension industry in line with the existing acts in South Africa (ii) CBL should consider allowing reputable South African pension managers, which are under effective supervision in South Africa, to operate within Lesotho subject only to an additional constraint that some portion of the funds mobilized in Lesotho be invested there (iii) Given serious economy of scale constraints, CBL should also consider subcontracting responsibility for supervising its pension companies to the South African supervising authority LNDC and BEDCO: It is recommended that: (i) no new lending be undertaken by either LNDC or BEDCO. LNDC's equity and real estate investment portfolios should be spun off from its entrepreneur development and training activities in the form of a new company which should be privatized. (ii) A BEDCO corporate strategy study should be undertaken to a) examine the feasibility of merging BEDCO with LNDC's non investment activities and making it the single focal point for training and promotion support for both small and larger scale industy; b) eliminating BEDCO's lending function and recommending a collection and disposition strategy for dealing with the largely moribund BEDCO and LNDC loan portfolios; and c) preparing a corporate strategy and business plan for BEDCO's ongoing operations. Leasing Finance: It is recommended that the government take steps for the establishment and the development of a leasing industry by: (i) the promulgation of a Leasing Act, which will indicate the rights, duties and obligations of participants and facilitate the adjudication of cases involving breaches of contract and which will be consistent of that available in South Africa to take advantage of development in this area (ii) attracting investors with experience in leasing to set up an operation in Lesotho and diversifying the sources of leasing finance by tapping insurance firns, pension funds and exploring opportunities for raising equity or bond financing (iii) the provision of technical assistance to SME's on the potential benefits of leasing, through workshops, seminars and other enlightenment mechanisms. D. Finance for Micro, Small and Medium Enterprises It is recommended that the government develops a Rural and Microfinance Strategy and Development Action Plan for meeting the financial needs of MSMEs which will include inter alia, (i) a careful assessment of the different kinds of Existing MFIs and the nature of their activities, scale and funding sources, as the basis for (ii) the definition of a regulatory and supervisory framework for MFIs guided by whether to, and how to supervise and regulate MFIs; and (iii) the creation of a rural and microfinance forum or association to serve as a body that will set standards for rural and microfinance services and provides a platform for discussion and information dissemination. 58 The Postal Financial Services. It is recommended that the LBP not be reestablished unless: (i) all control problems relating to accounting for deposits are solved; (ii) the private shareholders and the technical partner have been identified, a comprehensive business plan and modus operandi have been developed, and the overall implementation arrangements agreed upon; (iii) it operates only in locations for which anticipated volume of business will allow breakeven financial performance within a period of two years; and (iv) and it is not allowed to make loans. 59 Annex 2: Nedbank Balance Sheet 1999-2002 (M million and percent) _ 1999 2000 2001 2002 Cash 9.03 17.73 15.77 15.14 Balance with CBL 227.35 208.35 49.99 82.38 Balance w local banks 0.08 2.36 3.21 34.42 alance wbanks abroad 195.42 194.04 311.2 331.3 Marketable securities 0.0C 0.0C 143.61 235.72 Loans & advances gross 56.37 72.92 100.74 87.88 Provisions 12.80 15.97 19.0 16.21 oans net 43.57 57.05 81.68 71.68 Fixed assets 10.37 10.17 18.8 20.17 Other assets 14.36 17.60 29.77 4.6 Total assets 500.17 507.30 654.0 795.4 eposits 424.16 427.82 532.2 703.85 Balances due to local banks Balances due banks abroad 0.76 0.46 18.52 0.39 Other liabilities 25.86 26.13 61.3 31.5 Total liabilities 450.78 454.41 612.11 735.7 Share capital 20.00 20.00 20.0 20.0 Other reserves 29.39 32.89 21.98 39.71 Net worth 49.39 52.89 41.98 59.71 Liabilities and net worth 500.17 507.3 654.0 795.4 Contingencies & commitments 28.84 24.11 33.34 35.43 Net loan/deposit ratio 0.1C 0.13 0.15 0.1 Equity/total assets 0.1C 0.1C 0.0 0.0 Near cash assets/total assets 0.56 0.53 0.13 0.1 Marketable securities/assets 0.00 0.0C 0.27 0.33 oreign bank balances/assets 0.46 0.45 0.58 0.47 Loans maturing within 1 year 20.19 26.11 59.52 56.11 Maturing after one year 21.17 29.49 21.24 16.2 Non performing loans 15.02 17.32 19.99 15.4 % of loans under 1 year 0.36 0.36 0.5 0.64 % of loans over 1 year 0.38 0.40 0.21 0.1 /o of non performing loans 0.27 0.24 0.2 0.18 Demand deposits 294.82 300.04 357.52 495.9 Savings deposits 71.64 72.79 80.6 86.8 Time deposits 57.70 54.99 94.08 121.04 rime deposits within 1 year 40.70 37.99 77.08 121.04 Time deposits over 1 year 17.00 17.00 17.0 0.0 % of demand deposits 0.70 0.70 0.67 0.7 % of savings deposits 0.17 0.17 0.15 0.12 % of time within 1 year 0.10 0.09 0.1 0.17 % of time over I year 0.04 0.04 0.03 0.0 % time deposit 0.14 0.13 0.18 0.17 Market share deposits 0.26 0.26 0.31 0.37 Market share loans 0.24 0.33 0.37 0.28 Market share assets 0.26 0.24 0.31 0.34 60 Annex 3: Nedbank Income Statement 1999-2002 (M million and p rcent) 1999 2000 2001 2002 Interest income 59.9 44.3 52.7 71.7 Interest expense 24.8 19. 19.4 30.3 Net interest income 35.1 24. 33.3 41.4 ther operating income 8. 10.2 14.7 15. Total income 43. 35.1 48. 56.4 Overhead/net interest income 36. 43.2 48. 47. Staff costs 7.8 7.8 9.7 10.9 eneral admin expense 4.5 3. 7.7 10.1 Other operating expense 3.5 3.8 6.1 5.8 Total overhead 15.8 15.2 23.5 26.8 Provision for bad debt 0.3 0.4 0. 2.2 rofit before tax 27.8 19.5 24. 27.3 Tax 9.8 7. 8.9 9. Profit after tax 18. 12.5 15.1 17.7 Interest on advances 20.8 11. 11.5 nterest on deposits 23.2 36. 38. Interest on T-bills 0.3 4.9 21. Interest on demand deposits 13.3 12.3 17.5 Interest on savings deposits 1.8 2.3 3.2 Ierest on time deposits 4.3 4.8 9. Interest on customer deposits 0. 19. 19. 30.3 Interest on other deposits 24.8 0. 0. 0. verage total assets 212.1 426. 480.1 618.1 Income statement/avg assets Interest income 28.20/ 10.40/ 11.00/ 11.60/ Interest expense 11.70/ 4.60/ 4.00/ 4.9% Net interest income 16.60/ 5.80/ 6.90/ 6.70/ ther operating income 4.10/ 2.40/ 3.10/ 2.40/ Total income 20.70/ 8.20/ 10.00/ 9.10/ Staff costs 370/ 1.80/ 2.00/ 1.80/ eneral admin expense 2.10/ 0.80/ 1.60/ 1.60/ Other operating expense 1.60/ 0.90/ 1.3°/ 0.90/ Total overhead 7.5% 3.6% 4.9% 4.3% Provision for bad debt 0.10/ 0.10/ 0.10/ 0.40/ Profit before tax 13.10/ 4.6°/ 5.0°/ 440/ Tax 4.60/ 1.60/ 1.80/ 1.60/ Profit after tax 8.5% 2.9% 3.1% 2.9% Profit on equity 36.5% 23.6% 36.0% 29.7% 61 Annex 4: Standard Bank Balance Sheet 1999-2002 (M million and percent) 1999 2000 2001 2002 Cash 9.8 14.1 10.0 11.8 Balance with CBL 150.7 212.7 23. 29.0 Balance w local banks 13. 169.2 alance w banks abroad 79.5 136.3 78. 6.3 Marketable securities 10.5 56.9 272.2 241.1 nvestment in subsidiary 35. 35.0 35.8 35.8 Loans & advances gross 113.4 84.1 172. 230.6 Provisions 7.4 9.3 6. 16.3 Loans net 106. 74.8 66.4 79.0 Fixed assets 19.2 16.9 15.5 16.3 Other assets 19.7 27.3 17. 46.6 Total assets 430.4 574.1 532. 635.1 Deposits 318.2 397.2 360. 373.9 Balances due to local banks 97.5 Balances due banks abroad 22. 67.9 42. 66.2 Other liabilities 27. 39.8 42.1 24.3 Total liabilities 367.8 504.9 444.5 562.0 Share capital 16.5 16.5 16.5 16.5 Other reserves 46.1 52.7 71.5 56.6 et worth 62. 69.2 88. 73.1 Liabilities and net worth 430.4 574.1 532.5 635.1 Contingencies & conmmitments 82.1 30.3 60. 0.a Net loan/deposit ratio 330/ 19°/ 18/ 210/ quity/total assets 150/ 120/ 17/ 12°/ Near cash assets/total assets 500/ 570/ 13/ 560/ Marketable securities/assets 3'Y 140/ 76/ 650/ Foreign bank balances/assets 250/ 340/ 22/ 20/ oans maturing within 1 year 52.70 36.849 Maturing afterone year 42.392 27:734 23.31 33.431 Non performing loans 18.323 19.559 2.761 5.363 /o of loans under 1 year 46% 440/ 0 00/ /0 of loans over 1 year 370/ 33% 140 140/ /o of non performing loans 160/ 230/ 2/ 20/ Demand deposits 85.878 117.644 107.87 140.386 Savings deposits 115.184 115.023 122.84 124.977 rime deposits 117.10 164.505 129.661 108.5 Time deposits within I year 117.10 162.356 rime deposits over 1 year 2.149 /0 of demand deposits 270/ 30o/ 300 380/ /0 of savings deposits 360/ 290/ 340 330/ MO of time within 1 year 370/ 41°/ °0 00/ %/ of time over 1 year 00/ 10/ 0/ 0/ MO time deposit 370/ 410/ 360 290/ Market share deposits 190/ 240/ 210 190/ Market share loans 480/ 380/ 630 720 Market share assets 220/ 270/ 250/ 27%/ 62 Annex 5: Standard Bank Income Statement (M million and percent) 1999 2000 2001 2002 Interest income 47.8 40.1 43.3 53. Interest expense 11.4 7.5 9.4 11. Net interest income 36.4 32. 33.9 42.5 ther operating income 22.9 28.1 29.2 31. Total income 59.4 60.8 63.1 73. Overhead/net interest income 36.8 39.2 41.6 43. Staff costs 11.5 12. 13.9 16.5 General admin expense 6.9 8.3 7.1 7.2 Other operating expense 3.5 3.5 5.2 8. Total overhead 21.9 23.8 26.2 32.3 Provision for bad debt 0.3 0.3 0.5 4.2 Profit before tax 37.2 36. 36.3 37. Tax 11.2 10. 9.4 11.5 Profit after tax 26.1 26.7 26.9 25.5 nterest on advances 24.3 15. 12.4 11. Interest on deposits 21.7 24.1 13.0 11.7 Interest on T-bills 1.8 1.1 18.c 30. Interest on demand deposits 0.1 0.1 terest on savings deposits 2.2 2.5 Interest on time deposits 4.9 6.2 Interest on customer deposits 10.8 5. 7.2 8.8 Interest on other deposits 0. 1.5 2.2 2.3 verage total assets 159.1 357.7 378.8 367.1 Income statement/avg assets Interest income 30.10/ 11.20/ 11.40/ 14.6/ Interest expense 7.20/ 2.10/ 2.50/ 3.00/ Net interest income 22.90/ 9.10/ 9.00/ 11.60/ ther operating income 14.40/ 7.9O/ 7.70/ 8.50/ Total income 37.30 17.00/ 16.70/ 20.0/ Staff costs 7.20Y 340/ 3.7/ 450/ General admin expense 4.3°/ 2.30/ 1.9%/ 2.00/ Other operating expense 2.20/ 1.00/ 1.40/ 2.30/ Total overhead 13.7% 6.7% 6.9% 8.8% Provision for bad debt 0.20/ 0.10/ 0.1°/ 1.20/ Profit before tax 23.40/ 10.20/ 9.60/ 10.10/ Tax 7.o0/ 2.80/ 2.50/ 3.10/ Profit after tax 16.4% 7.5% 7.1% 7.0% Profit on equity 41.7% 38.5% 30.5% 34.9% 63 Annex 6: Lesotho Bank Balance Sheet (M million and percent) 1999 2000 2001 2002 Cash 17.0 18.5 26.1 27.4 Balance with CBL 159.9 37.2 2.8 36.3 Balance w local banks 97. alance w banks abroad 118.9 108.8 90.6 11. Marketable securities 641.7 761.8 658.0 754.3 nvestment in subsidiary 0. Loans & advances gross 67.5 66. 101.7 143.9 Provisions 0.7 0.7 2.6 9. Loans net 66.8 66. 99.1 134. Fixed assets 40.9 75.7 73.7 66. fther assets 14.3 14. 81.3 69.3 Total assets 1,059.6 1,082. 1,031.4 1,198. eposits 898.1 804.4 852.0 845.3 Balances due to local banks 192.2 Balances due banks abroad 61.2 92.3 13.0 3.4 Other liabilities 41.9 104.4 81.0 70.3 Total liabilities 1,001.1 1,001.1 946.0 1,111.1 Share capital 50.a 50. 50.0 50. Other reserves 8.5 31.5 35.4 37.5 Net worth 58.5 81.5 85.4 87.5 Liabilities and net worth 1,059.6 1,082. 1,031.4 1,198. Contingencies & commitments 0.a 6.1 4.3 0. Net loan/deposit 7.40/ 8.20/ 11.60/ 16.00/ Equity/total assets 5.5°/ 7.50/ 8.3% 7.30 Near cash assets/total assets 19.70/ 6.90/ 3.4/ 19.10/ Marketable securities/assets 71.50/ 94.70 77.20/ 89.20/ oreign bank balances/assets 13.20/ 13.50/ 10.6°/ 1.40/ Loans maturing within 1 year 28.3 25.4 31.5 173. Maturing after one year 39.2 41.3 70.2 23.8 Non performing loans 0.a 0. 0.0 1.9 /o of loans under 1 year 41.90/ 38.10/ 31.00/ 120.40/ /o of loans over 1 year 58.1°/ 61.90/ 69.0°/ 16.50/ % of non performing loans 0.00/ 0.00/ 0.00/ 1.30/ Demand deposits 142.8 138.1 204.1 205.5 Savings deposits 333.8 305. 318.3 349.7 Time deposits 383.6 309.9 289.5 290.1 deferred pay accounts 37.9 51.5 40.1 0. Time deposits within 1 year 359.1 289.4 272.6 ime deposits over I year 24.5 20.5 16.9 /o of demand deposits 15.90/ 17.20/ 24.00/ 24.3%/ % of savings deposits 37.20/ 37.9O/ 37.40/ 41.40/ % of time within 1 year 40.00/ 36.00/ 32.00/% 0.00 % of time over 1 year 2.70/ 2.50/ 2.00/ 0.00/ % time deposit 42.70/ 38.50/ 34.00/ 3430/ Market share deposits 54.70/ 49.40/ 48.8°/ 44.0%/ Market share loans 28.40/ 29.80/ 3730/ 45.20/ Market share assets 5440/ 51.00/ 48.10/ 51.60/ 64 Annex 7: Lesotho Bank Income Statement (M million and percent) 1999 2000 2001 2002 Interest income 55.5 101.4 90. 110.9 Interest expense 17.4 32.4 24.8 31.8 Net interest income 38.1 69. 65.2 79.1 ther operating income 7.1 14.2 19.8 32. Total income 45.3 83.2 85. 111.1 Overhead/net interest income 39.6 57.4 68. 80. Staff costs 7.4 25.4 28.2 34. General admin expense 9.2 17. 18. 24.2 Other operating expense 1.3 4. 11. 31.4 Total overhead 17.9 47.7 58. 89. Provision for bad debt 0.0 0. 1. 6. rofit before tax 27.3 35.5 24. 15.4 Tax 9.8 12.4 9.2 5. Profit after tax 17.6 23.1 15.4 9.9 nterest on advances 17.2 12.7 14. 20.1 terest on deposits 7.6 17.8 8.8 0.2 terest on T-bills 30.6 71.0 66.3 90. Interest on demand deposits 0. 0.8 terest on savings deposits 9. 9.2 Interest on time deposits 4.1 3. Interest on customer deposits 15.9 30.9 23. 28.2 Interest on other deposits 1.5 1.5 1.1 3.5 verage total assets 449.0 851.2 828.2 848. Income statement/average assets Interest income 12.4% 11.90/ 10.90/ 13.10/ Interest expense 3.9% 3.80/ 3.00/ 3.70/ Net interest income 8.5% 8.10/ 7.90 9.30 ther operating income 1.6% 1.70/ 2.40/ 3.8/ Total income 10.1% 9.8% 10.3% 13.1% Staff costs 1.6% 3.Q0 3.40 4.00/ General admin expense 2.0% 2.10/ 2.30/ 2.90/ Other operating expense 0.3% 0.60/ 1.40/ 3.70/ rotal overhead 4.0% 5.6% 7.1% 10.6% Provision for bad debt 0.0% 0.00/ 0.20/ 0.70 Profit before tax 6.1% 4.20/ 3.Q0 1.8° Tax 2.2% 1.50/ 1.10/ 0.70/ Profit after tax 3.9% 2.7% 1.9% 1.2% Return On Equity 30.1% 28.3% 18.0% 11.3% wb228339 Q:\My Documents\BSLl\Lesotho\Fin sector study\Lesoto Fin Sector 5 26 03\Lesotho Fin sect Rev Final Draft Report CBL's Comments Incorporated 04 07 04.doc April 7, 2004 3:18 PM 65 I i I i i i