Sri Lanka has seen a property price boom due to low interest rates, with large volumes of money being printed by the Central Bank to keep down rates and generate a balance of payments crisis from 2015.
Excessive exposure to property, especially commercial loans can lead to defaults, later expanding bad loans. In 2008 after pro-longed low interests and money printing from 2004, a number of finance companies collapsed.
To strengthen the financial system, the Central Bank was ready to impose "macro-prudential tools such as a sector-specific limit on the loan-to-value ratio, including the construction and real estate sectors," a revised agreement with the IMF said.
Sri Lanka first imposed higher loan-to-value ratios to curb credit to vehicles as low interest rates persisted and printed money was used to pay hiked salaries of state workers, and subsidies in a runway budget in 2015.
At the time, analysts warned that sector-specific administrative controls would not work as credit would then flow to a different sector as long rates are kept low with money printing. When rates are kept low with money printing by a central bank, the present value of long-term assets go up, generating a so-called asset-price bubble.
Car loans, which go to imports, are dissipated from the credit system unless the central bank prints money to sterilize forex interventions like in Sri Lanka. But, there are limits to sterilizing forex sales, and rate hikes are eventually forced with continuous forex reserve losses.
However, loans to land in particular keep money cycling within an economy, adding to a bubble.
However, interest rates are now higher, overall credit growth is slower and the Central Bank, instead of printing money, is buying dollars and mopping up part of the dollar purchases by selling down its Treasury bill stock, an action that tends to slow credit growth.
Central Bank Governor Indrajit Coomaraswamy who had now mostly brought the country out of the balance of payments crisis, said in May that a study on real estate credit was underway to find whether a bubble could be forming.
At a recent press briefing, a reporter requested Coomaraswamy to comment on claims said to have been made by developers that apartment sales had halved after his statement.
Coomaraswamy said it was advisable to double-check whether such a slowdown had started before or after his words. (Colombo/Aug11/2017- Update II)