Sri Lanka: Selected Issues
Author: International Monetary Fund
Publication Date:
03 Dec 2007
eISBN:
9781451823592
Language:
English
Keywords:
ISCR; CR; credit growth; private sector; credit standard; Sri Lanka's credit ratio; credit quality; lending boom; equilibrium credit; Credit booms; Commercial banks; Bank credit; Inflation; credit to GDP ratio
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This Selected Issues paper on Sri Lanka underlies the dynamics of growth and external competitiveness. The slowdown in the contribution of sectors that are labor intensive, together with faster growth in sectors that are capital intensive and have higher productivity levels, resulted in total factor productivity (TFP) as the main contributor to growth. Sri Lanka’s strong growth performance has brought positive benefits to the economy and has benefited from a high quality labor force. The labor productivity is low by regional standards and the internal terms of trade are skewed toward the nontraded sector.

Abstract

This Selected Issues paper on Sri Lanka underlies the dynamics of growth and external competitiveness. The slowdown in the contribution of sectors that are labor intensive, together with faster growth in sectors that are capital intensive and have higher productivity levels, resulted in total factor productivity (TFP) as the main contributor to growth. Sri Lanka’s strong growth performance has brought positive benefits to the economy and has benefited from a high quality labor force. The labor productivity is low by regional standards and the internal terms of trade are skewed toward the nontraded sector.

III. Macroeconomic Challenges of High Private Sector Credit Growth1

A. Background

1. Sri Lanka has been experiencing rapid private sector credit growth, fueled by robust growth in economic activity in a low, or sometimes negative, real interest rate environment. Over the last three years, annual growth in private sector credit has ranged between 22 percent and 26 percent, well above the 10-year average of 15 percent (Figure III.1). The credit expansion has been uneven across sectors of the economy. In particular, growth in consumer, housing, and financial sector lending surpassed 45 percent (y/y) in March 2007, raising concerns over excessive credit growth. Robust economic activity, rising personal incomes, capital inflows, and negative real interest rates have supported this credit expansion. On one hand, this phenomenon may be simply the result of financial deepening that will benefit the economy in terms of increased efficiency and economic growth. On the other hand, the recent expansion could reflect a credit boom with implications for financial stability. This note attempts to shed some light into the causes and consequences of rapid credit growth and key policy challenges. The note concludes that while the current expansion largely reflects financial deepening, sect oral risks have increased and asset prices have risen significantly. Continued monitoring of credit indicators as well as implementation of macroeconomic and prudential measures will be warranted to prevent an overexpansion in credit that could lead to overheating pressures, asset price bubbles, and deterioration in credit quality.

Figure III.1.
Figure III.1.

Sri Lanka: Growth of Bank Credit to the Private Sector

Citation: IMF Staff Country Reports 2007, 374; 10.5089/9781451823592.002.A003

Source: Central Bank of Sri Lanka; and IMF staff estimates.

2. The main stylized facts about private credit in Sri Lanka are similar to those in other countries in the region. Private lending is the dominant component of domestic credit, accounting for over ¾ of total credit. Flows through commercial banks constitute the most significant part of the overall intermediation, but specialized banks and finance institutions have become increasingly important and currently conduct 20 percent of all lending operations to the private sector. The share of credit extended to the private sector by state-owned banks has been declining for the last few years, in favor of domestic and foreign private banks, and currently stands at about 31 percent. In terms of maturity, more than half of all loans extended by commercial banks are short term (less than one year), albeit this share has been declining slowly since the 1990s. The main destination sector of private credit is trading (29 percent), followed by consumer loans (19 percent) and housing loans (16 percent). About 25 percent of total lending is in foreign currency, backed largely by foreign currency deposits (FCDs). The ratio of FCDs to rupee deposits has remained relatively stable over the past 5 years, at around 28 percent, but the stock of FCDs has increased from less than 7 percent of GDP in 1999 to around 8 percent of GDP currently.

B. Is This Rapid Credit Growth a Phenomenon of Financial Deepening?

3. Bank credit to the private sector (BCPS) as ratio to GDP has increased during recent years, but it is still low compared to India and other emerging countries in Asia. At about 34 percent of GDP, Sri Lanka’s credit ratio is slightly above the average for low-income countries in Asia, but significant below the ratio in India (53 percent) and in emerging Asia (91 percent).2 The cumulative change in the BCPS from 2000–06 was about 5½ percentage points, compared to 13 percent of GDP on average for low income Asia and 19 percent of GDP for India. When credit growth starts from a lower base, one can broadly expect that a high growth rate may be sustainable for a longer period. This is a phenomenon shared largely with other countries in the region, including Bangladesh, Nepal, and Cambodia (Table III.1).

Table III.1.

Selected Countries: Private Sector Credit

(In percent of GDP)

article image
Source: CEIC Data Company Ltd.

4. The recent increase may reflect, therefore, a catch-up effect from low levels. Indeed, the BCPS ratio is below the “equilibrium level” estimated for other emerging economies. For instance, Cotarelli and others (2003), Schadler and others (2005), and Tiffin (2006) estimate equilibrium credit to GDP ratios for transition economies in Europe and find that the predicted long-term values range between 65 and 75 percent. In addition, the BCPS ratio has not deviated substantially from its stochastic trend, suggesting that Sri Lanka is not currently experiencing a lending boom but increased intermediation that is consistent with the historically normal pace of credit growth. In Gourinchas and others (2001) a lending boom is defined as an episode where the BCPS ratio deviates from a rolling backward looking, country-specific trend that represents the historically “normal” pace of credit growth. Applying a Hodrik-Prescott (HP) filter to Sri Lanka’s BCPS ratio for the period 1970-2006, the absolute deviation of the BCPS ratio from the trend component in 2006 was estimated at 1.8 percent of GDP and the relative deviation was 5.4 percent. These values are considerably below the threshold risk levels considered in the paper—ranging from 4.8 percent to 6.4 percent of GDP for absolute deviations, and from 24.9 percent to 31.1 percent for the relative ones.3

5. The behavior of credit growth in real terms also suggests that the observed lending expansion may not be a lending boom. Real private credit growth has only ranged between 11½ percent and 15¼ percent since 2003. In Mendoza and Terrones (2004) a credit expansion in a given country is identified as a boom if real credit growth exceeds the standard deviation of that country’s credit fluctuations around trend (estimated using the HP filter) by a factor of 1.75.4 In Sri Lanka this threshold level is estimated at around 23 percent, which is significantly above the 14 percent real growth realized in 2006.

6. Sri Lanka’s private sector credit to GDP ratio is expected to increase further as its GDP per capita improves. As the literature has established, there exists a positive relationship between the level of economic development (measured by GDP per capita) and financial sector depth (measured as credit to the private sector to GDP). A simple regression analysis for low income and emerging Asia, suggests that Sri Lanka has a credit to GDP ratio lower than would be expected given its level of economic development (Figure III.2). This is also the case for other LICs in Asia, including Laos, Cambodia, and Bangladesh and two of the ASEAN-4 economies (Indonesia and Philippines). Sri Lanka’s transition towards emerging economy is, therefore, expected to be associated with an increase in both the demand and the supply for credit. Improvements in the financial infrastructure, adoption of new banking supervision and regulation practices (Basel II) as well as improvements in the legal framework relating to the financial system will greatly facilitate the supply of credit while containing underlying risks. In addition, the planned mega infrastructure projects, expansion in foreign direct investment and increased market liberalization are among the demand factors that will continue to support the expansion of domestic credit in the near term.

Figure III.2.
Figure III.2.

Sri Lanka: Credit to the Private Sector and Per Capita GDP, 2005

Citation: IMF Staff Country Reports 2007, 374; 10.5089/9781451823592.002.A003

C. Risks Associated with Rapid Credit Growth

7. Strong credit growth could increase macroeconomic risks and undermine financial stability. Empirical evidence for other regions suggests that episodes of rapid credit growth have often been associated with an overheating economy and a worsening of the current account. Overheating pressures could lead to inflation, and rising current account imbalances. When the level of external debt is high and reserves are below comfortable levels, rapid credit growth could make the economy vulnerable to sudden stops and balance of payment crises. Besides its impact on macroeconomic stability, rapid credit expansion can have important implications for financial stability. This will require banks’ risk management systems to be able to keep pace, thereby preventing lower credit standards and lower average quality of borrowers. Increased household indebtedness and loan concentration to specific sectors of the economy can also add to vulnerabilities. How is Sri Lanka managing the risks associated to rapid credit growth?

8. In recent years, increased intermediation in Sri Lanka has been accompanied by improvements in credit quality. Standard indicators of banking sector soundness are relatively strong. In particular, the quality of banking sector assets, measured by the volume of non performing loans (NPLs), has improved significantly and provisioning has increased by 60 percent since 2001. In December 2006, the NPL of commercial banks stood at 5.6 percent (from 14½ percent in 2002), while the net NPL ratio went below 2 percent. Most recent data for the first half of 2007 suggest that NPLs are maintained around the same level despite the strong growth in loans. Other indicators of capital adequacy and profitability have also risen (Table III.2). These improvements have been broad-based and observed in domestic, foreign as well as state-owned banks. The backward looking nature of these indicators, however, precludes an assessment of the impact of the most recent expansion on credit quality. Rapid credit growth may raise concerns about the future health of the banking sector and this calls for caution as regards assessing recent developments.

Table III.2.

Sri Lanka: Key Performance Indicators of the Banking Sector

article image
Source: Central Bank of Sri Lanka.

9. Notwithstanding the good performance on bank soundness indicators, stress tests reveal vulnerabilities to credit risk and interest rate shocks.5 It is estimated that if 10 percent of all borrowers in each loan category were reclassified and downgraded by one notch in all banks, the banking system would not be severely undercapitalized on average, but more than half of the banking system assets would undergo a reduction in their capital adequacy ratio below the 10 percent minimum capital requirement. In addition, more than half of the banking system assets are highly vulnerable to changes in interest rates due to large maturity mismatches between assets and liabilities in some large banks.

10. The recent acceleration in credit growth also poses liquidity risks as the growth of deposits has been outpaced by that of loans. The ability of banks to mobilize deposits has deteriorated as suggested by the large increase in credit to deposit ratios, by 6 percentage points in 2006 alone (Figure III.3). Banks have increased the share of their assets devoted to private credit (from 44 percent in 2002 to 57 percent in May 2007) and reduced the share of their deposit liabilities. Stress tests suggest that most banks’ liquidity positions would not be able to withstand moderate shocks to deposits and, unless additional deposit sources are mobilized, banks may face funding gaps in the near future. Underpinning the increasing trend in credit to deposit ratios are: (i) the widening spread between lending and deposits rates, which stands above 7 percent (Figure III.4); (ii) increasingly negative real interest rates during 2006; and (iii) the extensive use by commercial banks of the reverse repo facilities of the CBSL to obtain liquidity and finance the private sector during 2005-06, which reduced the incentives of the banks to attract alternative funding sources. Since January 2007, the CBSL has limited access to, and used moral suasion to discourage the usage of its reverse repo window, while allowing interbanks rates to increase substantially. This together with increased competition and efficiency in the banking sector should contribute to narrow the spread between lending and deposit rates and lead to a stronger deposit base. Furthermore, the recent moderation in inflation and the pickup in market interest rates should also have a positive impact on the growth of deposits relative to credit.

Figure III.3.
Figure III.3.

Sri Lanka: Private Sector Credit to Total Deposits (left scale) and Banks’ Net Foreign Liabilities (line, right scale)

Citation: IMF Staff Country Reports 2007, 374; 10.5089/9781451823592.002.A003

Figure III.4.
Figure III.4.

Sri Lanka: Lending and Deposit Rates

(In percent)

Citation: IMF Staff Country Reports 2007, 374; 10.5089/9781451823592.002.A003

11. The increased reliance on foreign funding in financing credit growth may increase external vulnerabilities. The growth of foreign liabilities has accelerated with the rapid expansion of credit, both public and private, increasing the vulnerability of the banking sector to external shocks (Figure III.3). At the same time, the foreign currency lending to foreign currency deposit ratio has increased from 79 percent in March 2005 to 111 percent in April 2007. A reversal of global conditions, including higher interest rates, could increase repayment difficulties for borrowers with substantial foreign liabilities.

12. Excessive private credit growth raises the risk of resurgence in inflation. One problem with rapid credit growth is the increased liquidity in the economy that could fuel inflationary pressures. In Sri Lanka, inflation started to accelerate from mid 2006 in an environment of strong credit growth and reached 19 percent in March 2007. As suggested by Figure III.5, inflation appears to be more synchronized with public credit developments than with private sector credit—the correlation between inflation and public credit growth is 0.8, while that between inflation and private credit growth is less than 0.3—and there have been episodes where inflation was declining while private credit was accelerating. Nevertheless, close monitoring is warranted, as private credit remains the dominant contributor to M2 growth and liquidity in the economy.

Figure III.5.
Figure III.5.

Sri Lanka: Inflation and Contributions of Public and Private Credit to M2 Growth

Citation: IMF Staff Country Reports 2007, 374; 10.5089/9781451823592.002.A003

13. Sectoral risks have also increased with credit flowing to some sectors of the economy and contributing to asset price inflation. Rising personal incomes—Sri Lanka’s GDP per capita reached $1355 in 2006, from $870 in 2002—has boosted households’ consumption and encouraged borrowing. Like in many other countries, the most rapid source of credit growth in Sri Lanka has been into property, and property prices have increased substantially. Mortgage and consumer lending, which account for 35 percent of total credit to the private sector, expanded by 41½ percent in 2006, well above the average aggregate credit growth, and accelerated to 60 percent and 45 percent, respectively, in March 2007 (Figure III.6). Financial sector lending is also growing extremely rapidly (60 percent in March 2007) while the services sector is experiencing negative credit growth. Very rapid credit growth, together with low loan diversification in banks’ portfolios, could accentuate credit and liquidity risks and increase the risks associated to real estate booms. Despite the lack of a real estate price index, there is evidence of buildup in asset price inflation, as suggested by the 20 percent annual growth in the cost of construction index, the 28 percent growth in land prices, and the 40 percent increase in the Colombo All Share Index during 2006.

Figure III.6.
Figure III.6.

Sri Lanka: Private Sector Credit 1/

(Year-on-year growth)

Citation: IMF Staff Country Reports 2007, 374; 10.5089/9781451823592.002.A003

Source: Central Bank of Sri Lanka.1/ Share in 2006 of the sector credit in total private sector credit in parantheses.

14. Excessive sectoral loan concentration could lead to a deterioration in household balance sheets, macroeconomic imbalances, and asset price bubbles. This concern is compounded by other macroeconomic risks, such as resurgence of inflation, higher interest rates and worsening in the security situation, that might affect some borrowers’ capacity to repay their loans. Under these conditions, banks’ risk assessment and risk management capacities are instrumental to avoid misallocation of credit and a decline in the average quality of borrowers.

15. other risks could stem from increased pressures to the current account associated with higher imports. During the second half of 2006 and first quarter of 2007, growth in consumer goods imports—that account for 20 percent of non-oil imports—was particularly strong (monthly average of over 30 percent). Higher wages and robust growth in remittances may have contributed to this strong growth, but it is crucial to continue monitoring consumer lending in order to identify potential risks. There is also evidence that investment imports are picking up (25 percent growth y/y in May 2007) and are expected to continue strong as implementation of the mega infrastructure projects keeps pace.

D. Policy Options

16. The policy response over concerns about excessive credit growth should in general include macroeconomic as well as prudential measures. In Sri Lanka, as elsewhere, a higher rate of growth can be sustained longer with positive impact in terms of financial development and growth if the monetary and financial systems are well managed. In this sense, the recent monetary tightening by the CBSL and the set of prudential regulations implemented during 2006 and 2007 are likely to have a positive impact on limiting financial sector risks and vulnerabilities. These measures include strengthening the requirements on classification and provisioning of NPLs (a general provisioning requirement of 1 percent was imposed on all performing advances of commercial banks), the introduction of a capital charge for market risk, and prudential norms for classification and valuation of the bank’s investment position. Furthermore, risk weights in respect of loans secured by primary mortgages over residential properties were increased and maximum limits of accommodation granted by banks were revised to address credit concentration risks. Going forward, the tight monetary stance should continue and prudential regulations should be strengthened to contain excessive exposures of banks to sectoral risks, improve their risk management infrastructure, and maintain underwriting standards for consumer loans, including credit card operations.

17. Implementation of macro stress testing is also instrumental to assess the resilience of the banking and financial sector and to assess sectoral risks. This could be supported by the implementation of Basel II in 2008, which is likely to address many of the banking credit risk concerns, as it requires banks to allocate enough capital on account of risks. Since bank lending behavior tends to be procyclical, it is important not to underestimate risks during the expansionary phases of the business cycle, as the one experienced in recent years in Sri Lanka. Credit standards should be tightened during these phases to avoid credit losses when the economic downturn occurs.

18. Since credit booms are not easy to identify, rapid credit growth should be a source of concern when it is accompanied by growing macroeconomic or financial imbalances. Credit booms are usually associated with investment booms, higher current account deficits, increased banks’ credit to deposit ratios, and increases in the price of nontradable goods and real state. These constitute warning signs for policy action.

E. Conclusion

19. The key policy question is how to minimize the risks of overheating and banking sector distress while taking advantage of the growth and efficiency gains derived from financial deepening. Sri Lanka has been experiencing for some time now credit growth above its historical average. While this can largely be associated with financial deepening, the cyclical upturn and favorable external financing conditions, it has raised concerns because loan concentration has increased. Rapid growth is expected to continue as Sri Lanka’s GDP per capita increases. This phenomenon might not necessarily be harmful for financial sector health if banks’ risks management systems are well functioning and appropriate macroeconomic policies are implemented. Close monitoring of credit indicators, in particular lending to the household sector, is needed to assure that Sri Lanka continues to reap the benefits of financial deepening without undermining macroeconomic and financial stability.

References

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  • Enoch C., and I. Otker-Robe, 2007, Rapid Credit Growth in Central and Eastern Europe: Endless Boom or Early Warning? (Washington: International Monetary Fund).

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  • Gourinchas, P., R. Valdes, and O. Landerretche, 2001, “Lending Booms: Latin America and the World,” Economia, Vol. 1, pp. 47– 99.

  • Hilbers, P., I. Otker-Robe, C. Pazarbasioglu, and G. Johnsen, 2005, “Assessing and Managing Rapid Credit Growth and the Role of Supervisory and Prudential Policies,” IMF Working Paper 05/151 (Washington: International Monetary Fund).

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  • International Monetary Fund, 2004, “Are Credit Booms in Emerging Markets a Concern?,” in World Economic Outlook: April 2004, Advancing Structural Reforms, World Economic and Financial Surveys (Washington).

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  • Lueth, E., 2005, “High Interest Spreads in the Banking Sector—Causes and Remedies,”in Sri Lanka—Selected Issues, IMF Country Report No. 05/337 (Washington: International Monetary Fund).

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  • Schadler, S., P. Drummond, L. Kuijs, Z. Murgasova, and R. van Elkan, 2005, “Credit Booms: Risks and Responses,” in Adopting the Euro in Central Europe: Challenges of the Next Step in European Integration, IMF Occasional Paper No. 234 (Washington:International Monetary Fund).

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1

Prepared by Marta Ruiz-Arranz.

2

Low-income Asia includes Bangladesh, Bhutan, Cambodia, Lao PDR, Mongolia, Nepal, Sri Lanka, and Vietnam.

3

This result is robust to changes in the sample period.

4

The threshold is motivated by the fact that, if yearly credit deviations from trend were normally distributed, there would be a 5 percent probability of observing these extreme values.

5

Aide-Mémoire, Sri Lanka FSAP Update, June 2007.

Same Series

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Cover IMF Staff Country Reports
Sri Lanka: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2007: Issue 374
Publisher:
International Monetary Fund
ISBN:
9781451823592
ISSN:
1934-7685
Pages:
50
DOI:
https://doi.org/10.5089/9781451823592.002
  • View in gallery

    Sri Lanka: Growth of Bank Credit to the Private Sector

  • View in gallery

    Sri Lanka: Credit to the Private Sector and Per Capita GDP, 2005

  • View in gallery

    Sri Lanka: Private Sector Credit to Total Deposits (left scale) and Banks’ Net Foreign Liabilities (line, right scale)

  • View in gallery

    Sri Lanka: Lending and Deposit Rates

    (In percent)

  • View in gallery

    Sri Lanka: Inflation and Contributions of Public and Private Credit to M2 Growth

  • View in gallery

    Sri Lanka: Private Sector Credit 1/

    (Year-on-year growth)

Sri Lanka: Growth of Bank Credit to the Private Sector

Sri Lanka: Credit to the Private Sector and Per Capita GDP, 2005

Sri Lanka: Private Sector Credit to Total Deposits (left scale) and Banks’ Net Foreign Liabilities (line, right scale)

Sri Lanka: Lending and Deposit Rates

(In percent)

Sri Lanka: Inflation and Contributions of Public and Private Credit to M2 Growth

Sri Lanka: Private Sector Credit 1/

(Year-on-year growth)