Fitch expects tepid banking sector interest for SL-issued ISBs and SLDBs

Despite the recent Central Bank (CB) measures, Fitch Ratings expects only a limited amount of new investments into Sri Lanka’s foreign-currency government securities, which includes international sovereign bonds (ISBs) and Sri Lanka Development Bonds (SLDBs), by the country’s banking sector amid concerns on the sector’s current exposure to non-investment grade foreign-currency government securities and potential funding access challenges.

Sri Lankan banks’ investments in ISBs and SLDBs accounted for 6.4 percent of the sector assets at the end of 2020, according to the rating agency. 

The Central Bank on June 16 revoked the previous indefinite suspension on investments in ISBs by local banks.
In addition, banks are also required to invest in high yielding ISBs and domestically issued SLDBs in equal proportion. The move is expected to increase investments in SLDBs by banks as the government is looking at SLDBs as a potential avenue to bridge the country’s external funding requirements.

Most recently, the CB announced a new US$ 100 million SLDB issuance by end of this month. 
The banking sector to-date remains the main investor in SLDBs. However, their holdings of SLDBs declined 15 percent in 2020 to Rs.448 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 Rating noted.

As Sri Lanka’s sovereign credit rating was downgraded by all three international credit rating agencies to deep into non-investment grade or junk status, banks’ ratings continue to remain constrained by the sovereign credit profile.
As a result, banks are also likely to continue to face difficulties in accessing foreign-currency funding.

By end of 1Q2021, foreign-currency borrowings declined to Rs.881 billion, from Rs.984 billion at the end of 2019, accounting for 5.8 percent of the banking sector assets.

Fitch Rating highlighted that refinancing needs of the sector remain high given that short-term loans made up around 63 percent of the banking system’s external debt at end-2020.

In December last year, the CB halted investments in ISBs by banks given the banks’ heavy investments into ISBs, which raised concerns on the pressure on the domestic foreign-exchange market through dollar outflows. 

Although, the latest CB measure has the potential to increase banks’ exposure to sovereign and foreign-currency funding and liquidity risks, Fitch Rating only expects a limited amount of new investments into both ISBs traded in the secondary market 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,” it said.

Further, the rating agency pointed out that risks to banks from their holdings of foreign-currency government securities were exacerbated by recent measures taken by the CB.

“…such as a reduction in the risk weights on foreign-currency claims on the government held by banks to 10 percent in 2021 from 20 percent, and cut in the loss-given-default rates to 10 percent from 20 percent when computing expected losses in 2021,” it noted. 

According to Fitch Ratings, ‘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 give rise to sustainability risks.