Fitch Ratings-London/Colombo-29 January 2020: A scheme for Sri Lankan banks to provide special credit support to SMEs this year should not have a material effect on banks' credit profiles, Fitch Ratings says. We believe that the scheme will prolong the resolution of non-performing loans only until end-2020, and delay capital repayments this year, but banks' improved liquidity due to a slowdown in loan growth in 2019 should mitigate the effects. The implications of the scheme for banks' stocks of restructured loans are likely to be limited, given the amount of loan restructuring that has already taken place. Restructured loans increased to 3.6% of gross loans across Fitch-rated Sri Lankan banks at end-September 2019 from 1.8% at end-2018.

Borrowers may still face difficulties repaying their obligations to banks unless Sri Lanka's macro-economic environment improves by end-2020, when the scheme is set to end. However, Fitch expects GDP growth to pick up to 3.5% in 2020 from 2.8% in 2019, which should ease pressure on borrowers.

The Central Bank of Sri Lanka launched the SME credit support scheme in January 2020, following several other measures from the authorities to stimulate economic growth through the banking sector, including a lending rate cap and an instruction to banks to cease recoveries on SME loans. The scheme applies to SMEs in manufacturing, services, agriculture (including processing) or construction, with annual turnover of LKR16 million-750 million in 2019 and total outstanding loans of up to LKR300 million at end-2019. It also covers loans to the tourism sector with a capital and interest moratorium until end-March 2020. Banks must apply the scheme by 31 March.

Borrowers covered by the scheme will still have to service loan interest while the scheme is in force, but banks must offer them a moratorium on capital repayments due in 2020 on all eligible Sri Lankan rupee loans. To the extent that banks have exposure to SMEs that take up this offer, their liquidity will be affected by the delay in capital repayments, but we do not expect liquidity shortfalls, particularly as liquidity is likely to have improved as a result of depressed loan growth in 2019.

The scheme also helps eligible borrowers with non-performing loans by requiring banks to defer until end-2020 any new resolutions to recover loans and advances under the Recovery of Loans by Banks (Special Provisions) Act, No. 4 of 1990. This law normally allows banks to pass a board resolution to take possession of mortgaged properties and sell them. In cases where such resolutions have already been passed, the SME credit support scheme requires banks to defer the auctioning of assets until end-2020. This will prolong the unwinding of non-performing loans through the recovery of collateral, but only until end-2020. We expect banks' asset quality to remain weak in 2020, with the resolution of non-performing loans likely to extend beyond 2020.