ECONOMYNEXT – Sri Lanka’s price controls on lending rates, which comes in the wake of a currency collapse and a spike in bad loans, will hit banks whose profits are already under pressure, Moody’s a rating agency said.

Sri Lanka’s soft-pegged central bank, which generated yet another currency collapse in 2018, due to contradictory money and exchange policies (juggling with domestic and external anchors) in a state failure, has slapped price controls claiming a ‘market failure’ critics say.

Up to 200 basis points in lending rate cuts were ordered.

“The lower lending rates will compress Sri Lankan banks’ net interest margins (NIMs) and add to their existing profitability challenges,” Moody’s Investors’ Services said.

“Narrower margins will strain bank profitability, which is already weakened because of rising credit costs and a higher effective tax rate.”

Currency collapses are coming thick and fast after the monetary authority started operating a highly unstable peg labeled ‘flexible exchange rate’ with discretionary policy where both money (liquidity management, rates) and exchange policies (convertibility undertakings) are skewed to permanently depreciate the rupee, analysts have noted.

Central bank driven ani-market interventions and monetary instability is coming as Sri Lanka’s foreign debt is inflating rapidly due to currency collapses and the country is running out of a stable environment for economic agents to engage in growth generating activity.

Currency collapses have come in 2008/2009, 2012 in 2015/2016 and after only a one year gap in 2018 under the ‘flexible exchange rate’.

After the 2015/2016 currency collapse there was only a one year respite of monetary stability in 2017.

By March 2018 the central bank started injecting liquidity (printing money) to generate another period of instability just as the credit system was recovering from the previous instability.

Prudent policy again reversed after July 2019 generating another period of instability, through private credit is weak, reducing the risk of another balance of payments crisis analysts have said. However with a fall in revenues from the 2018 currency collapse and credit contraction, there are risks of rising state credit.

Gilt yields have edged up, partly due to monetary instability and spooked foreign investors in rupee bonds.

The central bank earlier cut lending rates effectively expropriating depositors on a formula based on gilt yields. However

The Moody’s statement is reproduced below:

Sri Lanka’s lending rate cut is credit negative
for banks

On 24 September, the Central Bank of Sri Lanka (CBSL) mandated commercial banks
to cut lending rates on all Sri Lankan rupee-denominated loans by at least 200 basis
points beginning 15 October from rates set on 30 April 2019.

We expect banks’ NIMs to narrow after the lending rate cut since the cut’s immediate effect
more than offsets a more gradual decline in funding costs because of the time lag in the
re-pricing of time deposits. Narrower margins will strain bank profitability, which is already
weakened because of rising credit costs and a higher effective tax rate.

Among the three rated banks in Sri Lanka – Bank of Ceylon (BOC, B2 stable, b21), Hatton
National Bank Ltd. (HNB, B2 stable, b2) and Sampath Bank PLC (B2 stable, b2) – we expect
the negative effect on margins and profitability will be more pronounced for BOC because its
asset yields are lower than those of the other two banks (see exhibit). Furthermore, a modest
NIM reflects BOC’s already weak profitability, while its poor asset quality has contributed to
high credit costs.

Sri Lankan banks’ credit costs have increased substantially since 2018 because of systemwide
deterioration in asset quality amid weaknesses in the agriculture and construction sectors.
The country’s weak operating conditions following a constitutional crisis and the 2019 Easter

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Sunday terrorist bombings that killed 259 people exacerbated banks’ profitability challenges. In addition, the government introduced a temporary debt repayment levy in October 2018 that raised banks’ effective tax rate to more than 50% from 2019-21, further weighing on the banks’ bottom line.

With the lending rate cut, the central bank aims to stimulate economic activity and boost credit growth, which the country’s weak economy has dampened.

The central bank’s move comes amid an accommodative monetary policy in the past year, which did not lead to a reduction in lending rates. Since late 2018, the CBSL has adopted several measures to lower lending rates through a combination of lower reserve requirements, policy rate cuts and the introduction of a cap on deposit rates, which the CBSL removed shortly after the lending rate cut.

The CBSL also mandated that banks reduce the average weighted prime lending rate by 250 basis points by 27 December 2019 from rates as of 26 April 2019. The CBSL also introduced several other measures to curb lending rates, including a ceiling on rates charged on credit card advances, prearranged temporary overdrafts and penalty interest rates.