Lankan banks exposed to asset quality risks: Fitch

• Banks exposed to asset quality risks with outstanding foreign currency loans
• High external financing requirements place Sri Lanka at high risk unlike most Asia economies 
• Sharp slowdown in Chinese economy to have major negative impact on Asia’s banks
• Emerging market exposed to shift in investor sentiment away from risky assets and markets

A sharp slowdown in the Chinese economy would have a major negative impact on Asia’s trade-dependent banks while banks in Sri Lanka and Indonesia are exposed to asset quality risks from currency weakness with the shift in investor sentiment away from risky assets and markets.

Fitch Ratings in a new report said a slowdown in the Chinese economy and the resultant downturn economic conditions would test the asset quality and challenge the existing profitability of Asian banks though they have strong underwriting standards and risk controls.

“A severe slowdown in China would affect Asia-Pacific banks through three main channels - direct losses on mainland exposure, broader stress from a weaker regional economic environment, and market risks from a negative shift in global investor sentiment,” Fitch said.

The rating agency pointed out that the region’s emerging markets would generally be most exposed to a shift in investor sentiment away from risky assets
and markets.

“Most Asian economies have low external financing requirements relative to their international reserves, giving them a buffer against market pressures, but Sri Lanka is a clear exception, while Indonesia also has some vulnerability on this metric. 

Banks in Sri Lanka and Indonesia also have a significant proportion of outstanding loans denominated in foreign currency, which could expose them to asset quality risks from currency weakness,”Fitch noted.

Fitch Ratings’ hypothetical scenario models the economic impact of a sharp Chinese economic slowdown sparked by the US imposing additional tariffs of 25 percent on around US$300 billion of Chinese imports.

“The tariff impact is sharply amplified by a separate investment shock involving a substantial retrenchment in investment activity against the backdrop of corporates’ need to ease balance-sheet pressure and preserve liquidity amid weaker demand.Chinese GDP growth would trough at 3.4 percent in 2020, compared with a base case of 5.9 percent, before recovering to 4.2 percent in 2021,” Fitch said.

Outside of mainland China, the rating agency said Hong Kong banks have the most direct exposure to a Chinese slowdown, with claims on the mainland accounting for 30 percent of Hong Kong’s system assets at end-2018.

“We cut our assessment of the operating environment for Hong Kong’s banks to ‘a’/stable from ‘a+’/negative in 2018 due to the growing links between the territory and mainland China. Singaporean banks also have significant direct exposure.

Hong Kong and Singapore - along with South Korea and Taiwan - would also be hit the hardest through macroeconomic knock-on effects, given their close trade links with
mainland China.

A severe China slowdown could also undermine housing market sentiment and exacerbate home price corrections in markets where affordability is most stretched, most notably Hong Kong and Australia,” Fitch noted.