Fitch optimistic of banks’ recovery in private credit, economic activity

• Expects private credit to pick up during remainder of the year
• But wary of banks’ asset quality and risks stemming from sovereign credit profile

Sri Lanka’s banks would do well in 2021 despite the temporary setback in the second quarter due to virus related-restrictions as demand for private sector credit picks up on the expectation of possible recovery in economic activities during the remainder of the year, although risks continue to pose from the areas of asset quality and sovereign credit profile, according to Fitch Ratings.     

Although growth slowed to below historical averages, Sri Lanka’s banking sector emerged largely unscathed in 2020 despite the worst of the pandemic induced restrictions and its risks on non-performing loans and liquidity, defying the early expectations by Fitch Ratings as stimulus and regulatory relief measures took much of the sting out of an otherwise gloomier scenario. 

Sri Lanka’s licensed commercial banks grew their private sector credit by 6.4 percent in 2020 and is primed to accelerate it to 12 percent in 2021 notwithstanding the 2Q slowdown as credit to private sector in May grew by 10.5 percent form a year ago, up from 8.2 percent in April, Central Bank data showed.  

“Sri Lankan banks’ performance in 2020 and 1Q21 exceeded Fitch Ratings’ initial expectations, thanks to stimulus and regulatory relief measures,” Fitch Ratings said.

Sri Lanka’s banking sector reported its highest-ever quarterly earnings in the first quarter ended in March 2021 on higher growth in loans and decline in provisions for possible loans and other losses. 

“We expect moderately higher loan growth in 2021 as private credit demand picks up, alongside a possible resumption in economic activity combined with increased State borrowings,” the rating agency added.

Fitch forecasts banking sector loans to grow by at least 15 percent including the loans to the State sector. 

The growth in private sector credit is an important barometer of the economy as its pace signals the vibrancy of business, investment and consumption activities in the economy.  The Central Bank targets to expand private sector credit by Rs.750 billion in 2021, out of which Rs. 330 billion or 44 percent has already been achieved during the first five months, despite the lost momentum during April and May due to virus related restrictions. 

However, Fitch Ratings cautioned that asset quality remains a key risk as relief measures such as moratoria expire on a significant number of loans by August-end, including the latest round of payment holidays granted from May 15.  

While there won’t be a staggering uptrend in non-performing loans, the rating agency expects the asset quality matrices such as credit costs could be at least as high as in 2020 due to more pronounced asset quality deterioration.   

 
For instance, Fitch-rated banks’ aggregate impaired loan ratio fell marginally to 9.1 percent in 1Q’21 from 9.7 percent in 2020 on improved economic activity as borrowers serviced loans on time. 

“However, we expect it to deteriorate to around 10.5 percent by end-2021 as regulatory relief measures are unwound. We estimate at least 18 percent of Fitch-rated banks’ loans to have been under moratorium at end-2020 (1H20: 26 percent),” Fitch said. 

However, they expect the profitability to rise in 2021 due to improvement in margins from deposit re-pricing and higher loan growth. 

The banks have adequate liquidity to fund the growth in 2021, although the loan-to-deposit ratios of most banks reversed from the 2020’s downward trend seen from the record stockpiling of customer deposits in that year and the slowdown in demand for private credit.