Moody’s Investor Services said the credit guarantee scheme on pawning loans proposed by the Central Bank (CB) would have a positive impact on banks’ credit ratings.

This is because the new scheme will support the currently weak quality of their pawning loans, which constituted a substantial part of the recent increase in banks’ non-performing loans (NPLs).

“Although the government’s details on the mechanism are scant at this stage, we estimate that a partial guarantee is more likely because of the government’s constrained fiscal capacity and the history of government guarantees,” said Moody’s Associate Analyst Nick Caes.

However, Caes believes even a partial guarantee would be credit positive for Sri Lankan banks, given the current weak quality in gold-backed loans.
As at end-2013, Sri Lanka’s banking system’s gross NPL ratio increased to 5.6 percent from 3.7 percent a year earlier, with 75 percent of the total increase driven by pawning loan defaults.

This was at a time when the pawning loans accounted for 14 percent of the total loans in the system. Sri Lanka’s banks’ exposure to pawning loans is the highest in the world and even in India, the world’s largest gold consumer, this exposure is no more than 4-5 percent.  

In absolute terms, the Sri Lankan banking sector, let alone the non-bank financial sector, had pawning loans in excess of Rs.600 billion as at end-2012.
By end-February 2014, the CB data showed the NPLs had risen up to 6.5 percent demonstrating further loan defaults.

However, the banks, since the second half of 2013, reduced their loan-to-value (LTV) ratio of pawning to around 65 percent (from 80-95 percent) and also increased the lending rates to around 18.7 percent by end-2013 (from 17.5 percent a year earlier) to shrink their pawning portfolios by making them less attractive to the borrowers.

These measures contracted the pawning portfolio of the system by at least 17 percent in 2013, Moody’s measures.  

However, the new scheme will cap the interest rates at 16 percent per annum and also allow the banks to increase the LTV ratios up to 80 percent to revive growth in the segment to support credit flows to the economy, while mitigating the asset quality risk.

Although the new guarantee scheme will focus only on the new pawning loans, Moody’s expects the scheme will allow the existing borrowers also to refinance their pawning loans, perhaps even at a lower rate, leading to improvements in the quality of the asset class for the banks.

Despite the key policy rates remaining at extremely low levels, the Sri Lankan banking sector did not see the expected credit growth because the country’s private sector credit to a larger extent was fuelled by pawning loans.

In Sri Lanka, pawning is a popular means of funding the agriculture and SME sector with ease because of its inherent risk-free nature which prevailed until end-December 2012 before its prices starting to fall from its peak of US $ 1,800 per troy ounce in the world market.

While some specialists feel the gold prices are now bottomed-out, it is still trading at around US $ 1,200-1,300 levels.