Sri Lanka: Private Credit Growth Key To Banking Sector Recovery
Asia / Wed 06 Nov, 2024 BMI
Key View
Interest rate cuts by the Central Bank of Sri Lanka have reduced the margin boosts that commercial bank enjoyed over the last two years, and we expect monetary policy easing to continue.
The good news is that the economy is gradually improving, which should support credit growth and in turn banking sector profitability.
While challenges remain, the banking sector’s impairment coverage ratio and liquidity measures remain sound for now.
Further monetary policy easing will pose a headwind to commercial banks in Sri Lanka.
Disinflation remains well underway with the inflation rate falling to as low as -0.8% y-o-y in
October, significantly below the target rate of 5%. In response to that, the Central Bank of
Sri Lanka has started cutting interest rates, and we expect more cuts ahead to bring the policy
rate down to 6.0% by end-2025 from its peak of 15.5% in 2023. This will reduce the boost to
banks’ net interest margins that they enjoyed over the last two years (see chart below).
NIM Boosts Is Diminishing Sri Lanka - Deposit/Lending Rate &
Net Interest Margin, %
The good news is that the economy is gradually improving, which should support credit growth
and in turn banking sector profitability. GDP will rebound from a 2.3% contraction in 2023 and
expand by 4.5% in 2024 and 4.7% in 2025 on our forecasts. We expect credit demand to come
from the private sector. Indeed, household debt has returned to growth after contracting for
much of 2023, while the decline in corporate debt has gradually eased (see chart below).
Amid the ongoing fiscal consolidation, these two sectors have the potential to replace the fiscal
stimulus that drove credit growth in the past year.
NIM Boosts Is Diminishing Sri Lanka - Deposit/Lending
Rate & Net Interest Margin, %
One major hurdle to credit growth is the condition of bank balance sheets. The economic
downturn over the last few years has led to higher credit costs and concerns over bank
capitalisation. This may hinder the recovery in credit growth. Moreover, state banks with
high public sector debt exposure may come under pressure from Sri Lanka’s debt restructuring
with key creditors, including China. In particular, reduced interest rates from such restructuring
would affect their revenue streams. While we currently consider the upcoming September
presidential elections tail risk, it could cause slower economic growth and delay economic
reforms and debt restructuring under the IMF’s guidance. Such a situation will have a negative
knock-on impact on the banking sector.
Capital Adequacy Dipped, And Elevated NPL Risks Banks' Future Capital
Adequacy Sri Lanka - Capital Adequacy Ratio (LHC) & NPL Net Of Provision
To Capital (RHC), %
Another potential headwind is the recent dip in the banking sector capital adequacy ratio, even
though it has remained well above the regulatory threshold (see LHS above). Elevated non-
performing loan (NPL) ratios, which indicate that a significant portion of loans are not
generating income, pose additional concerns about banks’ capital adequacy. Indeed, the ratio
of NPLs (net of provisions) to capital in Sri Lanka has risen and remains significantly higher
compared to its neighbouring country, India (see RHS above). This points to further potential
stress on the banking sector's capital base, as banks may have to set aside more provisions
to cover potential loan losses.
Overall Financial Soundness Is Improving Sri Lanka - Total
Impairment Coverage Ratio & Liquid Assets To Short-Term
Liabilities
For now, the banking sector’s impairment coverage ratio and liquidity measures remain
sound (see chart above). The strengthening of the Sri Lankan rupee also reduces the burden
of foreign currency-denominated liabilities, which account for around 20% of total liabilities.
These factors will help to mitigate the challenges facing the banking sector.
This commentary is published by BMI, a Fitch Solutions company, and is not a
comment on Fitch Ratings Credit Ratings. Any comments or data included in
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