Abstract
Selected Issues
Sri Lanka’s Credit Expansion: Engineering a Soft Landing While Financing Growth?1
Private sector credit growth in Sri Lanka has recently moderated but continues to grow significantly faster than nominal GDP growth. Financial soundness indicators so far suggest a broadly healthy financial system and stress tests do not point to systemic risks. However, the rapid credit expansion of the past two years calls for heightened vigilance regarding potential underlying vulnerabilities, notably in the real estate sector. While monetary tightening in 2016–17 has helped to rein in credit growth, macro-prudential measures can be formulated and implemented to preempt emerging risks, including in the real estate sector. More generally, Sri Lanka will benefit from ongoing efforts to strengthen supervision and its macroprudential framework, as well as bolstering its crisis management and resolution frameworks.
A. Current State of Credit Growth
1. Over the last two years, Sri Lanka has experienced fast credit growth, beyond what its financial deepening needs would warrant. Sri Lanka’s credit to GDP ratio is among one of the lowest in Asian Emerging Markets and also low compared to several low-income countries (first graph in panel). However, while there is a need to deepen the financial sector in Sri Lanka, credit should expand at a sustainable pace. Sri Lanka has experienced several episodes of rapid credit expansion in the past, including in 2010–2012 (second graph in panel). Yet, the current credit expansion has not translated, like in the past, into higher levels of domestically financed private investment (total private investment excluding foreign direct investment) and in turn real GDP growth.2
2. While credit growth has moderated since mid-2016, further deceleration would help mitigate financial stability concerns. During 2016–17, the CBSL maintained a tightening bias and also introduced macro-prudential measures by imposing limits on loan-to-value (LTV) ratios on motor vehicle loans.3 Partly in response to these policy actions, credit growth to the private sector fell from its peak of 28.5 percent in July 2016 to 14.7 percent in December 2017. As a result, the change in the credit-to-GDP ratio is now below the crisis threshold of 3 percent, while the credit gap has narrowed to around 6 percent.4 In April 2018, the Central Bank of Sri Lanka (CBSL) cut the policy rate by 25 basis points in view of low inflation which also resulted in high real interest rates. Developments in credit growth as a result of this monetary loosening will need to be closely monitored as its effect is likely to come with a lag.
Current State of Credit Growth in Sri Lanka
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Sources: Central Bank of Sri Lanka, World Economic Outlook, International Financial Statistics, and IMF Staff CalculationsCurrent State of Credit Growth in Sri Lanka
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Sources: Central Bank of Sri Lanka, World Economic Outlook, International Financial Statistics, and IMF Staff CalculationsCurrent State of Credit Growth in Sri Lanka
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Sources: Central Bank of Sri Lanka, World Economic Outlook, International Financial Statistics, and IMF Staff CalculationsB. Assessing Underlying Risks in the Financial Sector
Credit Concentration in Construction
3. Notwithstanding the recent deceleration, credit growth remains elevated, particularly in the construction sector. Real estate market (personal housing and property development) expansion has continued unabated, and credit to construction is currently the highest contributor to overall credit growth. Currently, the real estate market makes up of 11.2 percent of total outstanding loans. Decomposed analysis of construction credit indicates that most of this credit has been utilized for personal housing, but credit to property development has also increased since 2014. Although the bulk of purchases of luxury condominiums, and some of the construction of office and hotel buildings, may reportedly rely on foreign financing, the increasing credit concentration in the real estate sector can lead to rising financial risks. If rapid construction leads to an oversupply in the real estate market, lower prices and a slowdown in construction activity would likely follow and trigger stress among the often-leveraged builders. Lower prices for luxury condominiums, even with few secondary market transactions, will depress the values of existing housing, entailing a negative wealth effect. Overbuilding would, through these channels, adversely impact the banking sector and economic activity.
Contribution to Credit Growth by Industry
(Y-Y Change, in pecent)
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Sources: Central Bank of Sri Lanka and Staff CalculationContribution to Credit Growth by Industry
(Y-Y Change, in pecent)
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Sources: Central Bank of Sri Lanka and Staff CalculationContribution to Credit Growth by Industry
(Y-Y Change, in pecent)
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Sources: Central Bank of Sri Lanka and Staff Calculation
Credit Growth in Construction and Land Prices
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Note: ‘Business Use’ refers to building and housing contractors, construction of business premises, hotels & restaurants as well as infrastructure development.Sources: World Economic Forum, World Bank and IMF staff Estimates.Credit Growth in Construction and Land Prices
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Note: ‘Business Use’ refers to building and housing contractors, construction of business premises, hotels & restaurants as well as infrastructure development.Sources: World Economic Forum, World Bank and IMF staff Estimates.Credit Growth in Construction and Land Prices
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Note: ‘Business Use’ refers to building and housing contractors, construction of business premises, hotels & restaurants as well as infrastructure development.Sources: World Economic Forum, World Bank and IMF staff Estimates.4. Standard indicators of banking sector soundness are broadly healthy but may not adequately capture underlying vulnerabilities. In December 2017, the NPL ratio of commercial banks stood at 2.5 percent with NPLs in the construction sector at about 3.5 percent. Other indicators of capital adequacy and profitability also point to a healthy financial sector. The backward-looking nature of these indicators, however, precludes an assessment of the impact of the most recent real estate-focused credit expansion on loan quality. More than half of the real estate loans were extended after 2014, making it difficult to assess their ultimate performance. Land prices have continued to increase since the onset of the credit boom in 2015 (outpacing the headline inflation). A significant slowdown in housing and construction could raise NPLs in real estate, raising concerns on the health of the banking sector.
Stress Test for an Adverse Scenario
5. The potential for a systemic crisis remains a tail risk, despite emerging vulnerabilities. An illustrative stress test of Sri Lanka’s banking system shows that the banking system would be able to withstand an adverse shock to the housing and construction sectors. The shock scenario assumes that 20 percent of construction loans default, with a loss severity of 60 percent, while 10 percent of retail mortgages default, with a loss severity of 30 percent. Under the assumed shock scenario, the capital adequacy ratio of 11 out of 26 banks decreases by more than 1 percentage point, but only two would see their CAR fall by more than 2 percentage points.5 However, about 10 banks would fall below the CAR required by Basel III in January 2019 under the scenario. These losses are not systemic in nature, although they would necessitate additional capital injections to remain compliant with Basel III requirements, which would range from Rs. 57 million to Rs. 21.1 billion.
Simulation Results- Post-Shock CAR vs. ΔCAR
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Note: A) The long-dashed line indicates the minimum 12.5 percent CAR required of all banks as of 1/1/2019. B) The dotted line indicates the minimum 14 percent CAR required of DSIBs as of 1/1/2019. C) The shaded area contains the six banks with a post-stress CAR more than 20 percent.Sources: FITCH Connect; and IMF staff.Simulation Results- Post-Shock CAR vs. ΔCAR
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Note: A) The long-dashed line indicates the minimum 12.5 percent CAR required of all banks as of 1/1/2019. B) The dotted line indicates the minimum 14 percent CAR required of DSIBs as of 1/1/2019. C) The shaded area contains the six banks with a post-stress CAR more than 20 percent.Sources: FITCH Connect; and IMF staff.Simulation Results- Post-Shock CAR vs. ΔCAR
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Note: A) The long-dashed line indicates the minimum 12.5 percent CAR required of all banks as of 1/1/2019. B) The dotted line indicates the minimum 14 percent CAR required of DSIBs as of 1/1/2019. C) The shaded area contains the six banks with a post-stress CAR more than 20 percent.Sources: FITCH Connect; and IMF staff.Growing Importance of Non-Bank Financial Institutions
6. Risks from rapid credit growth in Sri Lanka are further complicated by the growing importance of non-bank financial institutions. While banks are the main providers of private credit, private credit from NBFIs increased as a share of GDP from 5.8 percent in 2014 to about 8.4 percent in 2017 Q3 (loans almost doubled from about 0.5 billion rupees to about 1 billion rupees during this period). As NBFIs largely serve the riskier part of the population,6 periodic bankruptcies of NBFIs have occurred, with 6 NBFIs currently insolvent. The aggregate financial soundness indicators of NBFIs do not point to vulnerabilities and this sector is too small to constitute a systemic risk. Nevertheless, NBFI’s regulation and supervision need to be strengthened as the riskiness and importance of these companies increases. For examples, some NBFIs have been operating without a proper license, while the absence of a proper resolution framework for NBFIs has led to CBSL overseeing insolvent institutions for years at a time, often with budgetary impacts from restitution.
Loans and Advances from NBFIs
(Billion Rupees)
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Source: Central Bank of Sri LankaLoans and Advances from NBFIs
(Billion Rupees)
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Source: Central Bank of Sri LankaLoans and Advances from NBFIs
(Billion Rupees)
Citation: IMF Staff Country Reports 2018, 176; 10.5089/9781484362358.002.A004
Source: Central Bank of Sri LankaC. Policy Response
7. The authorities’ policy response to curb excessive credit growth should continue to include macroeconomic as well as macro-prudential measures. Prudent monetary policy by the CBSL as well as the implementation of macro-prudential measures have helped limit financial sector risks and vulnerabilities. As price stability is the prime (and sole) objective of monetary policy, a coherent monetary policy framework can stabilize inflation by ensuring that excessive credit growth does not fuel inflation. Going forward, a data-dependent monetary stance can ensure that the market lending rates are at the appropriate level to stem excessive credit growth so that inflation stays within CBSL’s targeted band. In certain countries, fiscal policy has also helped to curb excessive credit growth in the real estate sector. Currently, the CBSL also has two macroprudential policies in place to control credit growth: (i) LTVs on motor vehicles which were lowered in 2016/17 and have been effective in curbing excessive credit growth to this sector,7 and (ii) appropriate valuation procedures of immovable property (i.e, land and buildings) for use as collateral in securing loans. In addition, the authorities are expanding the land price index to ensure better monitoring of the real estate sector. Banks are implementing Sri Lanka’s Basel III requirements, with all banks scheduled to abide by the criteria set by CBSL by January 1, 2019, strengthening the banking sector by increasing capital buffers and requiring consolidation of banks that do not meet the thresholds. While these measures will be conducive to ensuring financial stability, Sri Lanka may benefit from designing a more holistic macro-prudential framework. Towards this goal, this section presents additional macro-prudential measures currently envisaged or that could be potentially included in the CBSL’s toolkit.
Banks
Better credit risk management. CBSL can continue to strengthen its supervision by (i) ascertaining that banks’ make sure that borrowers use loans in line with the stated purpose of those loans; (ii) assessing existing regulations on large exposures and align them with international best practices, as necessary; and (iii) conducting regular validation exercises to ensure accurate reporting.
Targeted macro-prudential policies. As part of the planned amendments to the central bank law i.e., the Monetary Law Act, the CBSL plans to strengthen its financial sector oversight. This could provide an opportunity to design a comprehensive and integrated macro-prudential framework to identify and assess potential threats to financial stability. Additional measures used in other countries which have helped address specific vulnerabilities, include: (i) improved sectoral asset classification to enable the introduction of sectoral concentration limits; (ii) increased risk weights applicable to real-estate loans; (iii) expedited collection of real-estate and personal income data to enable the introduction of limits on debt-to-income and loan-to-value ratios; (iv) consider introducing caps on debt payment-to-income (DTI) ratios that will cap the size of the debt service payments; (v) bring the Single Borrower Limit (SBL) and related-party lending regulations into line with international norms and apply the SBL at a consolidated level; and (v) utilize data from the credit information bureau in macroprudential analysis and continue to develop top-down stress testing.
Adherence to Basel III. The implementation of Basel III, that started on a staggered basis in July 2017, will address several of the issues related to banking stability, as it requires banks to hold additional capital against their risk-weighted assets. It will be important for CBSL to ensure that all banks continue to meet the implementation targets set forth by the CBSL so that banks are up to the new standards by January 2019. In addition, CBSL can improve its capacity to evaluate banks’ Internal Capital Adequacy Assessment Processes (ICAAP) and set bank- and finance company-specific minimum Capital Adequacy Ratios (CAR), which is also under the principles of Basel III.
Non-bank Financial Institutions
Strengthening non-bank supervision and regulation. The CBSL has started the resolution process of a few insolvent NBFIs and the Resolution and Enforcement Department started its operations from early January 2018 Further steps towards improvements in their supervision and regulation can be taken through key reforms including: (i) improve the surveillance of the wider financial sector to identify and shut down financial institutions operating without proper license; (ii) improve the risk-based supervision of NBFIs, and implement sufficiently strict and frequent audits of NBFIs to prevent large failures; (iii) develop and implement a resolution process for financial institutions based on global best practices; (iv) define explicitly the responsibilities of managers and owners of financial firms, and hold them responsible for wrongdoing; and (v) be transparent to all stakeholders about their responsibilities and the procedures the CBSL is using.
Sri Lanka: Policy Options to Limit Excess Credit Growth
If credit growth on real estate does not abate gradually or if there are renewed pressure on credit growth in this sector.
Sri Lanka: Policy Options to Limit Excess Credit Growth
| Macro-Economic Policies | |
|---|---|
| Policy Area | Policy Option |
| Monetary Policy | A data-dependent monetary stance to ensure market interest rates are at the appropriate level to stem excessive credit growth so that inflation stays within the central bank’s target band. |
| Fiscal Policies* (based on other experiences of other country) | Calibration of transfer taxes or stamp duties on real estate sales, which could be varied counter cyclically over booms and busts. |
| Prudential Policies | |
| Banking and NBFIs Regulation, Supervision, and Resolution | Implementation of Basel III to meet the capital requirements by Jan. 2019 as outlined by CBSL . |
| Enhancement of the regulations of NBFIs bringing it in line with commercial banks. | |
| Development of a framework to monitor and measure inter linkages among financial institutions. | |
| (i) Enhancement of the resolution framework; (ii) Assessment of the adequacy/limits on the deposit protection scheme. | |
| Crisis Preparation and Management Framework | Strengthening of the Financial System Oversight Committee by (i) setting up a working group on priority risks and (ii) developinga set of crisis prevention procedures. |
If credit growth on real estate does not abate gradually or if there are renewed pressure on credit growth in this sector.
Sri Lanka: Policy Options to Limit Excess Credit Growth
| Macro-Economic Policies | |
|---|---|
| Policy Area | Policy Option |
| Monetary Policy | A data-dependent monetary stance to ensure market interest rates are at the appropriate level to stem excessive credit growth so that inflation stays within the central bank’s target band. |
| Fiscal Policies* (based on other experiences of other country) | Calibration of transfer taxes or stamp duties on real estate sales, which could be varied counter cyclically over booms and busts. |
| Prudential Policies | |
| Banking and NBFIs Regulation, Supervision, and Resolution | Implementation of Basel III to meet the capital requirements by Jan. 2019 as outlined by CBSL . |
| Enhancement of the regulations of NBFIs bringing it in line with commercial banks. | |
| Development of a framework to monitor and measure inter linkages among financial institutions. | |
| (i) Enhancement of the resolution framework; (ii) Assessment of the adequacy/limits on the deposit protection scheme. | |
| Crisis Preparation and Management Framework | Strengthening of the Financial System Oversight Committee by (i) setting up a working group on priority risks and (ii) developinga set of crisis prevention procedures. |
If credit growth on real estate does not abate gradually or if there are renewed pressure on credit growth in this sector.
System-wide Reforms
Beyond the above-mentioned preventative measures, the following system wide reforms can be established to mitigate, in case a credit boom were nonetheless to materialize, the negative effects of a bust on the financial sector.
Comprehensive crisis preparedness and management framework. CBSL will benefit from introducing a framework for prompt corrective action in the event of a crisis. The interagency Financial System Oversight Committee and CBSL’s Financial System Stability Committee can play leadership roles in terms of providing guidance on systemic financial risk evaluation in Sri Lanka, and build a viable framework for the conduct of crisis operations that includes include crisis management plans and exercises. The capacity of the CBSL’s Macroprudential Surveillance Department can be strengthened further so it can provide appropriate support to the above committees and become a thought leader in crisis management.
Deposit Insurance Scheme. The current limit of the deposit insurance scheme was increased to Rs. 600,000 but remains low compared to other countries with similar per-capita income. It may be necessary to reassess the limit up to which the deposit insurance fund reimburses depositors to ensure that the threshold is appropriate.
D. Conclusions
8. Sri Lanka’s significant credit growth for more than two consecutive years warrants attention. While a portion of this credit growth can be associated with financial deepening, loan concentration, notably in the real estate sector, raises concerns. Current macro-financial indicators do not point to systemic risks but low NPLs may not be reflective of the underlying vulnerabilities calling for heightened vigilance. The authorities’ efforts to improve the financial infrastructure, adopt new banking supervision and regulation practices (Basel III) as well as revise the legal framework relating to the financial system (such as the Banking Law Act) will strengthen the financial sector and help maintain financial stability. In the short-term, the CBSL should maintain a prudent data-dependent monetary stance to ensure that excessive credit growth does not lead to inflationary pressures. The adoption of an overall macro-prudential framework would also strengthen financial stability. This framework can include measures such as loan-to-value ratio or higher risk weights on mortgages and construction, calibrated to the specific needs of Sri Lanka. Over the medium-term, policy efforts should continue to focus on strengthening the supervision and regulation as well as the resolution frameworks of both the banking and non-bank financial institutions.
References
Basel Committee on Banking Supervision (2010). Guidance for national authorities operating the countercyclical capital buffer, December.
Borio, C. and M. Drehmann (2009). Assessing the risk of banking crises – revisited, BIS Quarterly Review, March, pp 29–46.
Drehmann, M., C. Borio and K. Tsatsaronis (2011). Anchoring countercyclical capital buffers: the role of credit aggregates, Bank for International Settlements Working Paper No. 355, Basel, Switzerland.
International Monetary Fund (2011). Global Financial Stability Report: Grappling with Crisis Legacies, Chapter 3: Toward Operationalizing Macroprudential Policies: When to Act? Washington D.C.
Jones M. T. and M. Karasulu (2006). The Korean Crisis: What Did We Know and When Did We Know It? What Stress Tests of the Corporate Sector Reveal, IMF Working Paper 06/114, Washington: International Monetary Fund.
Lindner P. and S. E. Jung (2014). Corporate Vulnerabilities in India and Banks’ Loan Performance, IMF Working Paper 14/232, Washington: International Monetary Fund.
Prepared by Sarwat Jahan and Peter Lindner.
Average real GDP growth was below 5 percent during the rapid credit expansion of 2015–2017, compared to the episode in 2010–2012, when real GDP growth averaged 8.5 percent.
Following two policy rates hikes in 2016 and a third one in March 2017, market lending interest rates increased by about 300 bps since 2016. However, CBSL relaxed monetary policy in April 2018 which may impact credit growth.
Credit to GDP gap is a widely used indicator for financial sector stress. Following the Bank for International Settlements methodology, a threshold of 10 percent or more signals a high potential of crisis for advanced and emerging markets (Basel Committee on Banking Supervision, 2010; Borio and Drehmann, 2009; and Drehmann et.al., 2011). Another warning threshold is the year on year change of 3 percent in the credit-to-GDP ratio (IMF, 2011).
The stress test is based on end-2016 balance sheet data for Sri Lanka’s licensed commercial banks, as reported by FITCH Connect (FC). It should be noted that the two banks exhibiting the most severe losses have significant exposure to residential mortgages, many of which are collateralized with borrowers’ balances in the EPF pension fund. For background on stress test methodology, see Jones and Karasulu (2006), and Lindner and Jung (2014).
NBFIs provide lending to the underbanked portion of the population and SMEs, providing mainly vehicle loans, leases, and to a limited degree mortgages.
However, in January 2018, the LTVs on certain environmentally friendly motor vehicles was raised to support their greater use.
