June 25, Colombo: The end of the suspension on Sri Lankan banks’ investments in international sovereign bonds (ISBs) issued by the Sri Lanka sovereign (CCC) has the potential to increase banks’ exposure to sovereign and foreign-currency funding and liquidity risks, says Fitch Ratings.

Banks’ credit profiles are already significantly exposed to the sovereign, with Fitch-rated Sri Lankan banks having about a third of their combined assets exposed to the central government at end-2020. In addition, they face foreign-currency risks, including through their US dollar-denominated ISB investments (see Sri Lankan Banks Dashboard: 1Q21 published 9 March 2021.

The Central Bank of Sri Lanka (CBSL) on 16 June 2021 revoked the previous indefinite suspension on investments in ISBs by banks. Sri Lankan banks had invested heavily in ISBs, which prompted the CBSL to halt investments in ISBs by banks from December 2020, due to concerns about the pressure on the domestic foreign-exchange market through dollar outflows. The CBSL now permits banks to purchase ISBs in the secondary market, provided this investment is funded by fresh overseas borrowings.

The directive requires banks to adopt risk mitigation measures to bridge maturity mismatches that could arise. Fitch expects Sri Lankan banks to continue to face difficulties in accessing foreign-currency funding due to the sovereign’s low credit rating. Foreign-currency borrowings declined to LKR881 billion by end-1Q21, from LKR984 billion at end-2019, accounting for 5.8% of sector assets. Refinancing needs remain high as short-term loans made up around 63% of the banking system’s external debt at end-2020.

The latest directive stipulates that fresh offshore borrowings sourced to buy foreign-currency government securities have to be invested in both ISBs and Sri Lanka Development Bonds (SLDBs) in equal proportion, and as such would also contribute to increased investments in SLDBs by banks. Banks are the main investors in SLDBs, but their holdings of these securities declined 15% in 2020 to LKR448 billion. Take-up in SLDBs by banks has been less than the higher-yielding ISBs, which are listed and more widely held. There are no limits on banks’ subscription to SLDB issuances.

Fitch-rated Sri Lankan banks’ investments in ISBs and SLDBs accounted for 6.4% of their assets at end-2020. The extent of incremental investments in ISBs and SLDBs by banks remains to be seen, but Fitch expects the banks to add only a limited amount of ISBs and SLDBs. This is due to the lower appetite of some banks to add to their exposure to foreign-currency government securities and potential funding access challenges.

The risks to banks from their holdings of foreign-currency government securities are exacerbated by recent measures that have reduced minimum buffers, such as a reduction in the risk weights on foreign-currency claims on the government held by banks to 10% in 2021 from 20%, and cut in the loss-given-default rates to 10% from 20% when computing expected losses in 2021.

The ‘CCC’ rating on Sri Lanka reflects the sovereign’s challenging foreign-currency external debt repayment burden over the medium term, low foreign-exchange reserves, and high and rising government debt that gives rise to sustainability risks. Sri Lankan banks’ ratings continue to remain constrained by the sovereign credit profile.