“Fiscal and monetary policy tightening will reduce consumption and demand”

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An interview with Prins Perera, Senior Vice President of Treasury and Investment Banking at DFCC Bank

Following Sri Lanka’s decision to default on its external debt in April this year, several developments were announced by the government, including an interim budget, sweeping tax reforms and talks of downgrading Sri Lanka’s ranking in the status of the World Bank. These developments are closely linked to the banking sector, positively or negatively impacting the survival of the sector in times of economic crisis.

Q: What is the impact of the interim budget, the 2023 budget and recent tax reforms on the banking sector?

A: We have recently witnessed a further tightening of fiscal and monetary policies; however, it is not something that usually coincides.

Previously, we have seen one policy tightening while the other was more accommodative, to support economic growth and recovery.

However, in the current context, with the financing program of the International Monetary Fund (IMF), the two policies have been considerably restricted, which has led to a reduction in economic activity. In the first quarter, the Sri Lankan economy recorded a contraction of 1.6% year-on-year and a further contraction of 8.4% in the second quarter year-on-year. Economic growth in the third quarter could see an improvement.

The tightening of fiscal and monetary policies would directly impact consumer disposable income; therefore, the ability of customers to service loans could be compromised. Banks are expected to experience difficult financial conditions as government and private sector spending declines significantly, and this development could eventually impact bank performance.

Q: What is the liquidity position of the banking system, especially in the midst of the economic crisis and resulting developments?

A: At present, the liquidity shortage in the market is around Rs. 500 billion. This has been on the rise since the start of the pandemic. Currently, some market participants are borrowing around Rs. 850 billion through the CBSL Standing Loan Facility, while some are investing their excess funds of around Rs. 350 billion with CBSL through the Standing Depository Facility.

We also observed that some high net worth clients sensitive to credit risk shifted their deposits from local banks to foreign banks, which may have partly contributed to this imbalance.

Q: How is the lack of liquidity of Rs. 500 billion affecting the daily activities of the banking sector?

A: Key rates were revised in April from 6.5% to 7.5% and currently stand between 14.50% and 15.50%. During this period, the market saw a surge in government securities yields. Due to high interest rates, the market values ​​of treasury bill and treasury bond portfolios held by banks have declined sharply, negatively affecting CBSL’s borrowing capacity. This has created increased competition to solicit deposits to meet liquidity needs.

The lack of liquidity affects the Bank’s ability to lend to its clients, especially micro, small and medium-sized enterprises (MSMEs), as evidenced by the reduction in overall credit to the private sector in the banking sector.

At the same time, an increase in impairments was observed as customers could not repay their loans on time due to weak economic activities, high interest charges and increased working capital requirements. This situation has further worsened in part due to the sharp depreciation of the currency and longer working capital cycles.

Q: What is the impact of the current crisis on Treasury operations in Sri Lankan banks?

A: Dollar inflows into Sri Lanka have been hit hard. Looking at the statistics, it is evident that Sri Lanka received $6-7 billion in income per year in the form of workers’ remittances, $3-4 billion in foreign exchange earnings from tourism and $10-12 billions of dollars in export entries. With all this revenue combined, Sri Lanka managed the import expense bill, which was around $20-22 billion a year.

Q: The government is discussing with the World Bank a reverse graduation. This will allow Sri Lanka to access more concessional loans, but what would be the impact on the banking sector?

A: We have not yet assessed the impact. We have had discussions with a UK-based financial institution to determine the impact of such a downgrade on the banking sector. However, they too have yet to assess the impact this decision will have on the banks, as these external lenders perceive the current situation in Sri Lanka as a temporary problem.

Q: Moving on to DFCC Bank, what facilities do banks, especially DFCC Bank, have to facilitate import transactions?

A: This year, the overall volume of imports from Sri Lanka has been declining. The country imports about $2 billion per month, mostly oil, gas and coal products, in any given year. However, lately we have noticed that the monthly import spend has fallen below $1.5 billion due to import controls.

We are seeing progress in entries which have helped us deal with import transactions and opening LCs. We have also resumed accepting forward foreign exchange contracts for importing and exporting clients, allowing them to manage exchange rate volatility.

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