ECONOMYNEXT – Sri Lanka’s banks are facing higher bad loans as interest rates rise and the economy contracts the central bank said as the country in the those of the worst currency crisis in the history of the intermediate regime monetary authority.

Stage 3 bad loan had reached 10.6 percent of loans, while banks were also hit by mark to market losses and possible re-structuring losses.

Sri Lanka’s rupee collapsed from 200 to 360 to the US dollar in 2022 after two years of money printing blew the balance of payments apart and interest rates shot up to 30 percent and the economy is expected to contract more than 8 percent this year.

“The financial sector is likely to encounter significant challenges in the face of the current economic environment with the contraction in economic output, sovereign debt restructuring, high interest rate environment, tax revisions and high exposure of the banking sector to SOBEs,” the central bank said in a report issued before the budget.

“At present, an increasing trend in impaired loans is observed due to the present adverse macroeconomic circumstances and is expected to further increase in view of contemporary weak economic conditions despite the concessions granted to borrowers by the industry to confront the challenges.”

Sri Lanka has been hit by serial currency crises in 2015/16, 2018 and 2020/2022 under flexible inflation targeting where discretion is given to print money under an inflation target as high as 6 percent through multiple liquidity tools.

Each crisis is accompanied by an output shock and a spike in bad loans. The 2022 crisis was followed by sovereign default and there are concerns of domestic debt restructuring. The 2022 crisis came on top of a Coronavirus crisis.

The central bank had a plan to progressively build capital buffers and they were still above statutory minimum by August 2022. An end 2022 capital requirement had been deferred till 2023.

Now bad loans were rising fast.

“Asset quality of the sector deteriorated in terms of stage 3 loans to total loans ratio. Stage 3 loans increased by Rs. 475.1 billion, recording a growth of 56.9 % and reached Rs. 1.3 trillion as at end August 2022,” the central bank said.

“Furthermore, stage 3 loans to total loans ratio increased to 10.6 % by end August 2022 from 7.6 % as at end 2021 induced by the increase in stage 3 loans and lower growth in credit.

“…[B]anking sector stability may be threatened by rising challenges in maintaining its capital ratios above regulatory minimum levels and a substantial deterioration in capital buffers due to
the impact of adverse macroeconomic conditions.”