Rate cuts could deliver higher trading gains along with asset quality relief for banks– stockbroker

• But says any decision to restructure domestic debt could more than offset any rate cut benefits 

Sri Lanka’s banks could receive some earnings relief from a likely cut in interest rates in 2023, as lower rates have the potential to deliver trading gains on the bond portfolio they hold and a slight improvement in their asset quality, which will reduce their impairment provisions. 

Colombo-based brokerage CT CLSA Securities identified banking among three sectors that could outperform the rest in a declining interest rates scenario, as the stockbroker bets on rate cuts in early 2023. 
The other two sectors are consumer and capital goods. 

CT CLSA identified the three sectors based on their index performance and earnings growth in the 12 months after a rate cut, based on historical data. 

According to index performance, the banking sector has historically underperformed the total market in the 12-month period, post a rate cut. The All Share Price Index has risen by 12.6 percent after a rate cut but the banking sector index has lagged behind at 4.9 percent. 

However, based on the earnings performance, the sector has outperformed the market by growing its earnings by 4.1 percent in the 12 months, compared to the 4.0 percent growth in total market earnings.  
Even though CT CLSA expects the rate cuts to kick in somewhere this year, it does not expect a pivot in the current monetary policy until Sri Lanka obtains the Board level approval for the International Monetary Fund (IMF) bailout, which is likely in the second quarter of this year. 

“However, we believe that a dovish monetary policy will be adopted by the Central Bank of Sri Lanka once the country inks a deal with the IMF Board (currently said to be likely during early 2023E),” CT CLSA said.
However, the banks, which are currently going through a rough patch in terms of their earnings, could see an upside from a likely cut in rates, as the bills and bonds they hold will go up in value, enabling them to make trading gains. 

The yields and prices of bonds are inversely correlated. 
CT CLSA said such gains could be significantly high following a potential rate cut, given the sharply elevated rates at present. 

The low rates can trim the banks’ margins but given the exponential levels of the rate at present, any trading gains could easily offset the margin impact. On the other hand, unlike in a normal rate hiking cycle, the rates are currently in the restrictive territory, which has almost killed the sector growth.
Hence, there must be a substantial cut in the rates for banks to restart lending to offset any negative impact coming from narrowed margins. 

Meanwhile, the rate cut would also help banks to put a check on rising non-performing loans and thereby reduce the need for substantial provisions against potential loan losses.

For the nine months ended in September, the banking sector saw its Stage 3 loans, an equivalent for gross non-performing loans, rising to multiyear highs of 11.2 percent, causing jitters for the sector executives. 
Meanwhile, CT CLSA said any decision to restructure domestic debt could more than offset any benefit coming from the rate cuts, depending on how material such a decision would be.