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Mark Young head of Asia Pacific Financial Institutions at Fitch Ratings said with weaker credit growth there was room for an improvement in the indicator.

Fitch put Sri Lanka's financial system on category '3' when credit growth was high and there was a stock market bubble, amid fears of a spillover over to property.

"Number 3 suggests high potential for system risk," Young said. "How are indicator works it is driven by three areas: credit growth, potential for asset price bubbles and real exchange rate.

"If two of those three are above trend, we hit number three. Number 3 suggests high potential for system risk."

A Fitch report released in December 2011 revealed that Fitch had placed Sri Lanka's financial system on a high-risk category ( Sri Lanka among high risk financial systems: Fitch).

In August 2011, LBO's economics columnist also warned (Sri Lanka can avoid currency trouble with consistent policy: fuss-budget that Sri Lanka was heading for a balance of payments crisis after data showed that the island was sterilizing foreign exchange sales with central bank credit (printed money).

"To head off any 'balance of payments' problem the central bank has to weaken the rupee or allow interest rates to go up," the column warned.

"If neither happens, credit expansion is on track to crash land in the balance of payments."

In 2011 Sri Lanka's government started subsidizing energy with commercial bank credit, at a time when credit growth was already high, pushing imports to unsustainable levels.

The central bank then started to sterilize foreign exchange sales with liquidity injections giving further ammunition for banks to give credit, delaying a rate increase and driving up aggregate demand to unsustainable levels.

Sterilizing forex sales with liquidity injects new cash into the banking system, allowing banks to give loans over and above their deposits and loan repayments.

Typically the Central Bank will take Treasury bills in bank balance sheets to its own by rejecting bids at weekly Treasury bill auctions to generate excess demand, increasing the loan- to-deposit ratio of the banking system.

But eventually loss of foreign reserves forces a correction, pushing up interest rates.

"At one point lending rates will no longer make economic sense for some businesses. They will start to default," the the column warned.

"By this time banks will also be borrowing at high rates. Then deposit rates will hit levels where it makes no sense even for banks and finance companies to borrow. Bad loans will damage bank balance sheets."

In some cases (when lenders are badly damaged) bank runs could also be triggered, the column said.

In previous episodes of balance of payments troubles, such as in 2004 the state got printed money to supplement the budget by directly selling Treasury bills to the Central Bank after foregoing taxes due from an energy utility.

Analysts say energy subsidies have always figured in Sri Lanka's balance of payments crises, including the most recent ones in 2000/2001 and 2008/2009, and a key risk to the economy could be eliminated by having automatic price adjustments.

Young said Fitch's Macro-Prudential indicator may be upgraded in the future, though it has to remain for three periods after it was last triggered.

"It will be there for a while. It is backward looking," Young said. "It just gives the reader or user and indication that there were potential risks in the system and it was primarily rapid credit growth and potential for asset bubbles."

Young said some of the risks have come through and is seen in an increase in bad loans.

"So now you see much lower credit growth in Sri Lanka," Young said.

"So at some point we would expect Sri Lanka not to be on 3. It may come to 2 or 1. The exact timing I am not sure."

In Asia among Fitch rated countries, China, Hong Kong, Mongolia and Indonesia remains in the red. Vietnam which was in the category '3' has now been placed on '2'.

Update II

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