Sri Lanka: Exchange Rates remains Unpredictable

Sri Lanka Exchange Rate USD/LKR remain highly unpredictable due to FX shortages expected to be faced by the banks.

Banks could face significant capital and FX shortfalls as a result of a sovereign debt restructuring. A sovereign debt restructuring will crystalize both sovereign credit risk and FX risk facing the banks. Banks’ exposure to the public sector as of end-September 2022 amounts to
33 percent of projected 2022 GDP, more than 5 times their total capital of 61⁄2 percent of GDP. Staff’s analysis indicates that, the illustrative restructuring scenario considered in the public debt sustainability analysis (Annex II), combined with a severe asset quality shock consistent with the economic downturn, could result in capital shortfalls for some banks. Private sector capital may be difficult to secure until the economy has stabilized, especially for the state-owned banks. The authorities have therefore committed in the MEFP to a plan for potential bank recapitalization and the DSA includes a contingent liability to reflect this.

Moreover, banks’ net open foreign exchange position would deteriorate significantly as a result of a sovereign debt restructuring. The depreciation of the rupee has increased the share of FX assets from 16 percent at end-2021 to 25 percent of banks’ assets. Restructuring of public FX debt, or repayment in rupees could cause banks’ FX liabilities to significantly exceed their FX assets. These FX short positions could lead to more losses if the rupee depreciates further, if banks are unable to secure sufficient FX inflows. Thus, banks and the authorities will also require a plan to close the net open FX position in the banking sector.

Banks Exposures in foreign currency include holdings of Sri Lanka’s International Sovereign Bonds (ISBs) and Sri Lanka Development Bonds (SLDBs), and state-owned bank loans to SOEs and the government. While banks have made substantial provisions against their holdings of ISBs in 2022, these still imply lower losses than market valuations of these bonds, which currently trade at prices below 40 percent of par. 

Banks therefore remain vulnerable to losses arising from debt restructuring. In addition, most local currency government bonds are now accounted for on an amortized cost basis and are booked at well above their current market value, as 10-year T-bond yields have risen to around 28 percent from 12 percent at end-2021.