Sept 15, Colombo: Sri Lanka bank ratings are unaffected by the downgrade of Sri Lanka’s Long-Term Local-Currency Issuer Default Rating to ‘RD’ from ‘C’, says Fitch Ratings.

On 14 September 2023, Fitch downgraded the sovereign’s Long-Term Local-Currency Issuer Default Rating following the completion of an exchange of treasury bonds for longer-dated ones, which forms a part of the broader domestic debt optimization program. The exchange of treasury bills held by the Central Bank of Sri Lanka (CBSL) has yet to be completed.

We do not believe the completion of the first phase of the restructuring of the sovereign’s local-currency obligations is likely to trigger a loss of depositor confidence in the banking system, leading to a widespread default within the financial system, including for non-bank financial institutions (NBFIs). As such, we expect the banks to continue to service their local-currency obligations, given their better funding and liquidity profiles relative to that of the sovereign.

Fitch continues to maintain the Rating Watch Negative (RWN) on Sri Lanka banks and NBFI’s ratings to reflect the potential for deterioration in their creditworthiness relative to other entities on the Sri Lankan national ratings scale. This reflects near-term downside risks to credit profiles from spill-over effects from the remainder of the sovereign’s debt restructuring, while access to wholesale foreign-currency funding remains constrained. Further clarity around the sovereign debt restructuring process, particularly on the foreign-currency debt, that points to a reduction in stresses that have affected the banking sector in the past several quarters, would result in a resolution of the RWN with affirmation of the bank ratings.

While the local banks have been spared from the rupee debt restructuring, we believe that the broader economic conditions remain challenging as reflected in the expected contraction of the economy and high volatility of economic variables. This may still place downward pressure on individual credit profiles, particularly for NBFIs, which tend to be more exposed to cyclically sensitive segments. We believe that the re-assessment of the sovereign credit profile following the completion of the debt exchange with CBSL will influence the ratings of the banks and NBFIs, given the high interconnectedness.

While the domestic debt optimization program is nearing completion, uncertainties prevail over the completion of the foreign-currency sovereign debt restructuring. Any doubts over this could weigh on the banking sector with spillover effects to the NBFIs, given the banks’ exposure to defaulted foreign-currency sovereign bonds, albeit they make up a small share of sector assets (3.6% of assets at end-1H23).