Central Bank releases Financial Stability Review for Year 2023

The Financial Stability Review (FSR) of 2023 which encapsulates the developments in the financial system, the risks and vulnerabilities identified thereof, and the policy measures taken by the Central Bank and other regulatory institutions in addressing such risks during the review period, was released on Friday.

Excerpts from the FSR 2023 and the financial stability outlook are given below.

The financial sector, which experienced an unprecedented array of challenges in the aftermath of the economic crisis, continued to operate under challenging conditions. The overall economic contraction during the nine months ending September 2023 coupled with tax hikes aimed at supporting fiscal consolidation; and elevated price levels and interest rates resulted in strained balance sheets of economic agents. Accordingly, financial intermediation1 witnessed a considerable decline reflecting the subdued demand and supply conditions for credit amidst a considerable deterioration in credit quality.

Financial sector exposure to the Government continued to increase amidst the fall in overall credit growth, highlighting imbalances that pose challenges to the financial sector. While the approval of International Monetary Fund’s Extended Fund Facility (IMF-EFF) in March 2023 brought in confidence, ensuing developments such as uncertainties about the sovereign debt restructuring process and the results of the bank diagnostics exercise raised some concerns on the sector.

With these developments, financial markets which witnessed extreme turbulence in 2022 demonstrated signs of stabilisation. Financial market’s stress as indicated by the Financial Stress Index remained broadly at low levels in the first ten months of 2023 as overall market conditions significantly eased compared to 2022. Volatility of share market indices gradually subsided though investors continued to be attracted to high yield investments in the form of Government securities.

Meanwhile, banking sector stocks also depicted high sensitivity to the Government debt restructuring process reflecting their high exposure to the sovereign. Comparatively subdued domestic macroeconomic conditions together with tight global financial conditions resulted in a low level of foreign investments in the domestic equity market.

The anomalous interest rate structure in terms of elevated yields in the Government securities market gradually declined, although not completely, mainly supported by the dissipation of uncertainties following the Domestic Debt Optimisation (DDO) announcement, downward adjustments in the policy rates, reduced inflation, and anchored inflation expectations. The foreign exchange market which recorded an acute shortage of liquidity resulting in a significant depreciation of the Sri Lankan Rupee during 2022 witnessed an appreciation of the domestic currency with a gradual easing of liquidity conditions.