Â RatingScoreRatingScore
       Overall assessmentC51C48
       Financial riskD67D63
       Note: E=most risky; 100=most risky.SUMMARYThe managed exchange rate regime was replaced with a theoretically free-floating system in early 2001. The currency has been subject to bouts of volatility, often owing to political instability. Financing in local markets is limited largely to bank credit, although there is a relatively well-developed stockmarket. Credit ratings agencies have a local presence, which has helped companies raise funds through debt markets. The government obtained a sovereign rating from the main global ratings agencies in 2005. Both the stock and bond markets will remain illiquid. Foreign companies are able to tap the capital markets, but approval may be required depending on their status and the currency being sourced. The banking sector has high (though declining) levels of non-performing loans, but most of these are held by state-owned banks and denominated in the local currency. As a result, there is little chance of a banking sector crisis. The supervisory powers of the Central Bank of Sri Lanka have risen in recent years.SCENARIOSThe Sri Lanka rupee suffers a steep depreciationV High likelihood; Moderate impact; Intensity =15The rupee has been fairly stable since it was allowed to float in 2001, but is subject to bouts of volatility when it can depreciate. The rupee is especially vulnerable to a crisis of confidence resulting from political instability, in particular whenever there is a surge in the ethnic conflict. In 2008 the abrogation of the ceasefire agreement between the Liberation Tigers of Tamil Eelam and the government in January 2008 and a deteriorating outlook for the economy should have placed increasing downward pressure on the currency, but instead the rupee has appeared unusually stable against the US dollar (although the US currency has itself experienced a bout of weakness). This suggests the government is managing the currency increasingly actively, heightening the risks of a dramatic movement should foreign currency inflows fall—for example, as a result of weakening apparel exports. Currency stability is further undermined by continuous deficits on the current account and relatively low levels of reserves. Companies should ensure that contracts reflect exchange rate risk when agreeing on payment terms. Hedging, when possible, is advisable.Financing availability is constrainedModerate likelihood; Moderate impact; Intensity =9The banking system as a whole is quite developed, but shows evidence of fragility. The sector is dominated by the two large state-owned banks, but both are weak and saddled with high levels of bad debt. Since most of this debt is guaranteed by the government, there is little chance of a systemic banking crisis. However, high public debt levels constrain the ability of the government to bail out the sector. Private banks are better managed, but these too suffer from high levels of non-performing loans, dampening lending. Foreign investors may access local credit markets for rupee borrowing, but high interest rates may be a deterrent. To by-pass this foreign investors can make use of US dollar-denominated debt facilities, which charge dollar-based interest rates. Depending upon the nature of the services required, it might be prudent to place savings in more than one domestic bank to avoid losses from a possible banking crisis; there is no deposit insurance. Foreign banks are likely to be more stable than domestic institutions.BACKGROUND(Updated: August 21st, 2007)Financial ServicesSri Lanka's financial sector has grown rapidly in recent years, both in terms of the number of institutions and the scope of services offered. The sector was liberalised in 2003, when the government allowed 100% foreign ownership of commercial banks, insurance services and stockbroker services. The government also privatised the insurance sector. Several steps were taken in 2003-04 to enhance the systemic stability of the sector. Capital adequacy ratios were raised, and provisioning requirements made more stringent. The Central Bank of Sri Lanka lifted minimum capital requirements for commercial banks from SLRs500m (US$5m) to SLRs2.5bn (US$25m), and raised those for savings banks and finance companies from SLRs200m to SLRs1.5bn. Banks have been given until the end of 2007 to comply. Credit ratings for all deposit-taking institutions are now mandatory. In 2006 the Central Bank tightened regulations further by introducing a cap on shareholdings in commercial banks and specifying single borrower limits for companies, to prevent individuals or groups (of owners or borrowers) exerting excessive influence over banks.The dominance of the banking sector in the financial industry has grown: it accounted for 71% of assets in 2006. Bank coverage has improved, with an expansion in the branch networks of the main commercial banks. Intense competition among banks has also led to rapid growth in value added services, such as automatic teller machines (ATMs), credit cards, telebanking and Internet banking. It has also encouraged increased financial intermediation.Besides expanding services, the banking sector is also undergoing structural changes. Mergers, acquisitions and strategic alliances, among both commercial banks and other financial institutions, are becoming more common. The distinction between commercial, development and other specialised banking services has been blurred. Development banks have diversified into insurance and fund management, for example, and have increased their lending capacity by acquiring strategic stakes in commercial banks. Commercial banks, whose main source of business is trade financing, are financing development projects (through loan syndication) and moving increasingly into consumer credit and housing finance.A persistent weakness of the banking system has been high intermediation costs. These are reflected in the interest rate spreads offered by Sri Lankan banks, which are significantly higher than those in other countries in South Asia. Fundamentally, high costs stem from poor credit-management techniques (high levels of bad loans increase dependence on the fewer sound loans for income) and high operating expenditure. Other problems include the need to mobilise long-term deposits held at fixed rates, high taxes and statutory costs, and overdependence on interest-earning activities for income. Although the financial soundness of the banking system has improved, the non-performing loan (NPL) ratios of commercial banks are still relatively high at 12.6% in 2006. This is partly attributable to the lengthy and cumbersome legal procedures involved in debt recovery, which make dispute resolution a protracted and costly experience.A major weakness in the financial sector is the fact that it is dominated by the state. Through its ownership of the two largest commercial banks, the Bank of Ceylon and the People's Bank, and more recently in 2006 through the creation of a new development bank, the state's presence in the banking sector is substantial. It also has a virtual monopoly on the management and use of long-term savings (through two pension funds and the largest savings bank), and consumes over 50% of domestic financial resources, primarily to finance government borrowing. The pre-empting of long-term savings funds by the state has constrained growth in the private debt market.Under a restructuring plan, net profits and deposits at the Bank of Ceylon and the People's Bank (which has benefited from a recapitalisation programme financed by the Asian Development Bank—ADB) have risen, and the ratio of NPLs has fallen. Nevertheless, the banks still remain vulnerable to political interference, in the form of issuing loans that stand little chance of being repaid.The insurance industry has grown since its privatisation but only accounts for a mere 2.9% of total financial assets. The industry is dominated by two companies that together account for 72% of assets.Sri Lanka's capital markets are relatively underdeveloped, but have grown in recent years. The declining trend in the stockmarket since 1998 was reversed after the election of a coalition government led by the United National Party in December 2001. In 2002 the Colombo Stock Exchange (CSE) became one of the best-performing markets in the world, with the All-Share Price Index (ASPI) rising by 31%, and the Milanka sensitive price index surging by 33%. Market capitalisation nearly doubled in 2003, reaching SLRs263bn by the year-end. Despite political and security tensions in 2004-06, the CSE has remained strong. In 2004 the ASPI climbed by a hefty 42%, and in 2005 an initial public offering (IPO) from the leading mobile-phone operator, Dialog GSM (owned by MTN Networks, a subsidiary of Telekom Malaysia), caused the ASPI to climb above 2,000 points in 2005, and hugely boosted market capitalisation.Escalating violence between the government and Tamil rebels in 2005-07 has led to increased volatility, and some declines in the stockmarket. However, the CSE has proved fairly resilient; by end-2006 the ASPI rose by 42% year on year, to 2,722, and market capitalisation increased by 43%, to SLRs835bn—equivalent to 30% of GDP. The number of listed companies, however, remains relatively limited.Although there is an active market for government securities, the private debt securities market is small. However, the decision in 1999 by a leading credit-rating agency, UK-based Fitch, to establish a local branch and issue local ratings encouraged more companies to move into bonds and debentures. It has also encouraged more companies to seek credit ratings in preparation for listing on the stockmarket.Foreign reserves and the exchange rateForeign-exchange reserves fell by almost 50% between 1998 and 2000, undermined by a decline in FDI and an overall balance-of-payments deficit in 1999-2000. This was followed by a marked improvement, with reserves (excluding gold) rising from US$1bn in 2000 to US$2.8bn in 2006, according to IMF figures. Increased inflows in the form of private remittances, FDI, public- and private-sector long-term borrowing and net portfolio investment all helped to shore up reserves. Inflows associated with aid related to the end-2004 tsunami disaster have also served to prop up foreign-exchange reserves.Foreign-exchange reserves, 2006
       Â TotalPer head
       Â (US$ bn)(US$)
       Sri Lanka2.8135.7
       Sources: IMF, International Financial
Statistics; Economist Intelligence Unit, CountryData.

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