During 2022 and the first half of 2023, businesses in Sri Lanka were battling the highest interest rates the country had ever seen as people were forced to pay over 30% to access credit, with interest rates increasing consecutively.

While interest rates have come down with the Central Bank of Sri Lanka (CBSL) easing its policy rates, according to CBSL Governor Dr. Nandalal Weerasinghe’s latest comments, market interest rates have not reduced as expected.

In 2023, policy rates dropped by 5.5%, while the three-month Treasury bill (T-bill) rate dropped by 18.1% and the Average Weighted Prime Lending Rate (AWPLR) by 15.1%.

However, in 2024, the three-month T-bill rate declined by 4.3% and the AWPLR declined by 1.1% as of Monday (25), prior to the CBSL monetary policy rate cut. On Tuesday (26), the CBSL reduced the monetary policy rates by 50 basis points, with the Standing Deposit Facility Rate (SDFR) reduced to 8.50% and the Standing Lending Facility Rate (SLFR) reduced to 9.50%.

The AWPLR stood at 10.69% at the end of the week compared to 21.40% a year ago, following the reduction of the policy rates by 50 basis points.

Market rates have not reduced as per CBSL expectations

Speaking at the Monetary Policy Review briefing held on Tuesday, Dr. Weerasinghe said that when the policy rates reached 8.5-9.5%, under normal circumstances Government securities rates such as T-bill rates should also move closer or within the policy rate corridor, adding: “We have already seen that happen last month and this month.” 

He said that once the benchmark rates moved in line with the policy rates, other market rates were also expected to fall in line. 

However, Dr. Weerasinghe said that a gap premium in the market rates, even in the AWPLR and Average Weighted Lending Rate (AWLR), could still be seen and that those adjustments would have to take place soon.

“We hope that banks will continue to bring down the market rates in line with policy rates as well as benchmark rates,” the Governor said, adding that the market rates were yet to fall in line with the CBSL’s policy rates under normal circumstances in the current easing cycle.

Rates cannot drop sans single-digit T-bill rates 

Speaking to The Sunday Morning, a senior banker from a leading private bank who wished to remain anonymous said that the lending rates had reduced significantly compared to what they had been in 2023.

He said that although January had not been an entirely favourable month, when considering the last two quarters of 2023, private credit picking up could have been due to the reduction in interest rates.

The banker observed that the CBSL Governor was perhaps expecting interest rates to drop to single digits: “However, a drop of 8-9% for lending rates would be quite drastic, because our interest rates for one-year deposits are still at 8-9%.”

He noted that should both lending and deposit rates match, banks would then start incurring losses, adding that while the lending rates had not come down to 8-9%, they had nevertheless reduced drastically.

The banker said that when the T-bills had not come down to single digits, the lending rates could not be in single digits as people always benchmarked the bank interest rates with the T-bill rates to get a higher return.

Further, he said that if inflation was going to be at 5-6%, expecting lending rates to reduce to single digits was a tough ask. He added that it was too early to decide whether the suspension of parate law would have an impact on the interest rates as it had only been a week since the suspension had been implemented.

However, he said that the percentage of the loans on which parate law had been executed was not significant considering past statistics, as most of the loans given by banks were not based on collateral but on cash flows.

According to CBSL data, in the past five-year period, there have been 2,262 parate executions, recovering loans amounting to Rs. 114 billion, which is 1% of the total outstanding loans of the banking sector as at end-2023.

The banker said that external debt restructuring did not play any role in the behaviour of banks’ interest rates, although these rates carried huge risk premiums before the implementation of domestic debt restructuring.

However, he added that there was an element of uncertainty when it came to banking sector performance and stock prices as the book value of most banks was undervalued.

Private credit will positively impact interest rates 

The banker also said that a demand for credit was accompanied by a demand for money, which would play a role in driving up interest rates.

“However, I believe that even interest rates will stabilise, because creating credit in the banking sector increases the money supply as well,” he said, adding that whenever credit was created, money creation would correspondingly multiply as the loan taken from the bank would be deposited in the same bank or another with interest added to the deposit.

Similarly, the money supply that comes from Government securities such as T-bills and bonds will only serve Government purposes which can only place a certain amount of pressure on the interest rates.

“What we really need is this amount of money creation, but not for consumption purposes as we had earlier during the economic crisis,” the banker said. Private sector credit will play a role where interest rates will have a positive impact on the economy through money creation. 

T-bill, bond rates expected to decline

The CBSL Governor said that the T-bill rates had come down to the policy rate corridor and then increased again in March, which was the month in which the highest amount had been collected from the market for the first time in history through T-bill and bond auctions.

“There won’t be a huge demand for bonds in the coming months from the Government. Therefore, we expect the rates to come down again,” he said.

He also said that the CBSL expected private credit growth to continue with the reduction in interest rates and if inflation remained at 4-5%, there would be space for monetary policy to reduce further in the easing cycle. 

Dr. Weerasinghe added that if inflation remained between 4-5%, there would be more space for the monetary policy to ease in the current easing cycle, adding that it would depend on the latest forward-looking indicators, credit cycle, economic recovery, and market interest rates.

He also said that there could be an increase in interest rates when banks provided credit with the suspension of parate law. 

Outstanding high domestic debt stock affecting interest rates 

Speaking to The Sunday Morning, Frontier Research Macroeconomic Risk Advisory Head Chayu Damsinghe said that the primary reason for the high Government securities interest rates, which was the biggest driver of all other interest rates in the market, was the high amount of short-term domestic debt payments that still remained due.

He said that although the T-bill stock had reduced in January and February, it had started to tighten again from March onwards. He added that the T-bill stock, which had been at Rs. 4.07 trillion as of the end of 2023, had reduced to about Rs. 3.9 trillion by the end of March, which was still quite high.

“When you have such a large debt stock, you need to convince the market that it needs to be paid a decent enough interest rate to keep rolling it over. This is impacting the way banks and primary dealers make their decisions,” he said.

Impact of external debt restructuring on interest rates 

Damsinghe further noted that while external debt restructuring had a sentimental impact on interest rates, there would be no other significant impacts, because external influence on the domestic rate was overwhelmed by the fact that the domestic debt stock was so large.

Further, he said that delaying external debt restructuring would not immediately impact the amount of domestic debt as Sri Lanka was not accessing the external market in any case. 

“However, it does affect the pathway forward; if people think the way forward is negative, there can be a risk premium on the interest rates,” Damsinghe cautioned.

He said that getting a single-digit market interest rate as expected by the CBSL Governor was difficult because the market had to consider that such an interest rate was adequate.

He further noted that interest rates played a function in economic risk and the expected return: “It’s essentially at a point where the market considers whether the 9% return is good enough. Therefore, it is very much a sentimental question and not a fundamental question of the economy.”

Suspension of parate weighing on bank interest rates 

Speaking to The Sunday Morning, CT CLSA Head of Research Oshadha de Vas Gunasekara said that the suspension of parate execution was weighing on decreasing interest rates.

“Banks are somewhat reluctant to lend, probably at the lower rate, due to the suspension of parate execution,” he said.

However, he said that interest rates would start to move downwards with the reduction of policy rates and T-bill rates.

He added that in the past few weeks, the T-bill auction sizes had been substantial, which had temporarily pushed the rates up. However, the auction sizes are expected to reduce in April, depressing T-bill rates and thereby overall market rates.

Accordingly, the T-bill auctions held in the first three weeks of March offered Rs. 160 billion, Rs. 180 billion, and Rs. 155 billion, respectively, as the three-month T- bill rate went from 9.87% to 10.10% during the period. 

Gunasekara said that T-bill maturities in the next two to three months were relatively on the lower side. “Government securities rates can drop to single-digit levels in the next one or two months,” he added.

Moreover, he said that market interest rates falling to single digits would also depend on how fast banks were lending, as the average of the rates had to be taken into consideration.

He also said that while sentiments could be weighing the interest rates, when considering the bigger picture, rates would decline in any case, since people were now moving into equities on account of the rates not being very attractive.

Single-digit interest rates possible by June 

According to Gunasekara, the market interest rates are likely to reach single digits around June, after which a slight increase in interest rates will be seen in the second half of the year with the increase in credit demand.

Further, he said that if the Government continued to borrow from the domestic market in the second half of the year, it would essentially result in a crowding-out effect, which could push the rates up.

“If the Government can secure funding from bilateral and multilateral sources following the completion of debt restructuring, there won’t be much pressure on domestic rates,” he said.

Companies comfortable with 9-11% interest rates

Speaking at a webinar held by Capital Alliance Limited (CAL) on Thursday (28), Singer Sri Lanka Group Chief Executive Officer Mahesh Wijewardene said that companies would be comfortable with bank interest rates remaining in the range of 9-11%.

He said when considering the past 10-15 years, average bank interest rates had been around 9-11%. “It was the most stable rate we had ever faced; it could have been lower than that, but it only dipped for a very short period,” he added.

Wijewardene said that having interest rates in the range of 9-11% was manageable, as businesses were aware that it would not be easy for the rates to drop to very low levels, since they would not be able to survive in a high-interest environment.

Further, speaking at the webinar, Hemas Consumer Brands Managing Director Sabrina Esufally said that recent interest rates had been lowered in the current manner since consumption was not picking up.

“We certainly hope this will stimulate consumption, and if that happens, we have to anticipate that the interest rates will rise,” she added.