Sri Lanka’s MSMES at a crossroad: How central bank policies led them towards a debt abyss

By Ranul Seneviratne

Micro, Small, and medium-sized enterprises (MSMEs) are the cornerstone of Sri Lanka’s economy, contributing over 50% to the nation’s Gross Domestic Product (GDP) and employing a significant portion of the workforce. These micro, small, and medium enterprises (MSMEs) play a critical role not only in job creation but also in addressing gender disparities, with 25-35% of MSMEs being women-led, particularly in rural areas.

The vulnerabilities in Sri Lanka’s policy framework became particularly evident during the economic crisis that unfolded between 2018 and 2023. Approximately 8.3% of MSMEs—equivalent to 108,100 businesses—ceased operations during this period, creating conditions that disproportionately harmed MSMEs, which are vital to Sri Lanka’s economic and social fabric.

This article comprises two separate sections:

PART 1 – We will look into the current landscape of Parate Executions in Sri Lanka and their impact on various stakeholders.

PART 2 – We will try to understand the root cause of this debt crisis seen among MSMEs and what chain of events resulted in the current predicament.

PART 1 – WHAT IS PARATE?

Parate execution, rooted in Roman Dutch Law, allows licensed commercial banks to sell mortgaged property without judicial oversight, based solely on a board resolution. This mechanism was incorporated into Sri Lanka’s Parate Law under the Recovery of Loans by Banks (Special Provisions) Act, No. 4 of 1990. The law enables banks to recover unpaid loans efficiently by auctioning mortgaged assets once debts exceed LKR 5 million and other recovery methods have been exhausted. Its non-judicial nature offers speed and flexibility, benefiting banks.

THE GOVERNMENT’S DECISION TO SUSPEND PARATE EXECUTIONS AND THE SUBSEQUENT LIFTING OF THE SUSPENSION

On November 28th, 2024, the Sri Lankan government took a decisive step by suspending Parate executions, aiming to offer temporary relief to struggling MSMEs amidst the nation’s ongoing economic challenges. This measure effectively paused the immediate seizure of assets by banks, providing businesses a window of opportunity to renegotiate debts and stabilize operations. While the move has been welcomed by many as a lifeline for SMEs, it has also ignited a broader debate about its long-term impact. The suspension highlights the delicate balancing act between safeguarding vital businesses and addressing the banking sector’s liquidity and stability, both critical to Sri Lanka’s economic recovery.

However, we at ADVOCATA believe that while it is important to safeguard MSMEs from possible bankruptcy, extending this suspension of Parate may actually be more harmful in the long run. Keeping in line with this view, the government of Sri Lanka also seems to have understood that extending Parate further would bring far more detrimental consequences to the economy. Hence, as a result, the government announced on December 18th that the suspension of Parate executions would be lifted in March 2025. We will now delve into how this decision affects key stakeholders in the economy, including businesses, banks, and the government, while examining its broader implications for financial stability and growth.

BUSINESSES

Analyzing the effects of lifting the suspension on Parate executions must be done with care. While it may seem that this decision could result in struggling MSMEs—a critical lifeline of the economy—shutting down, this assumption is not entirely accurate. Halting the immediate seizure of assets provides a window of opportunity for some companies to renegotiate their debts and stabilize operations, but only a few businesses will enjoy this benefit.

As of November 2023, the number of distressed businesses falling under the “Loans by Banks (Special Provisions) Act, No. 4 of 1990” was small. Banks had recovered only Rs. 38 billion through Parate executions on 557 individuals, accounting for just 2.7% of Stage 3 impaired loans and 0.4% of total loans provided—a modest contribution to resolving the bad debt crisis engulfing Sri Lanka’s MSMEs.

Prolonging the Parate suspension prevents the settlement or renegotiation of distressed debts. Lifting the suspension will help banks and authorities identify borrowers exploiting the “Parate suspension” to delay and avoid repayments despite being capable of fulfilling obligations, undermining repayment culture.

BANKS

For banks, lifting the suspension brings major benefits in the short run. Resuming debt repayments improves their balance sheets and asset quality, and provides opportunities to renegotiate with borrowers and restructure non-performing loans (NPLs). Conversely, the suspension prevented prompt recovery of assets tied to NPLs, increasing liquidity risks. The accumulation of unresolved bad loans weakens bank capital, limiting their ability to issue new loans.

The International Monetary Fund (IMF) has cautioned that prolonged suspensions could erode investor confidence and strain credit risk management. Allowing banks to reprocess property of distressed MSMEs who fail to respect debt obligations will reduce the current high-risk premiums charged when lending. However, this move may also encourage asset sales at low prices, increasing foreclosure costs and liquidity drain.

PART 2 – THE ROOT CAUSE OF THIS HIGH DEBT BURDEN AND MSME FAILURE

THE PROGRESS OF THE BUSINESS CYCLE

Sri Lanka’s current MSME sector crisis reflects the re-adjustment process following an artificial economic boom created by an abundance of easy money injected into the banking system. Classical Economists like Ludwig Von Mises and Friedrich A. Hayek explain this well in the “theory of money and economic fluctuations.”

At the start of a boom, cheap credit encourages borrowing. Entrepreneurs, optimistic about profits, take loans to fund production. This creates economic expansion but also drives up wages and production costs. Entrepreneurs take more loans, assuming investments will pay off. As borrowing increases, demand for loans outpaces supply, raising interest rates. Entrepreneurs then cut costs, lay off workers, and reduce operations. Excessive borrowing becomes unsustainable, leading to defaults. Non-Performing Loan (NPL) ratios in Sri Lanka hit 13.2% in September 2022 due to Stage 3 loans surging by 53.6%, reaching Rs. 1.3 trillion. The construction sector, notably affected, had a Gross Stage 3 Loans Ratio of 15.0%.

CENTRAL BANK’S ROLE IN THE CRISIS

Sri Lanka’s Central Bank’s monetary policy framework played a decisive role. Aggressive rate cuts and liquidity injections created a “deadly cocktail” that disproportionately harmed MSMEs. Mispricing interest rates incentivized unsustainable lending in low-productivity sectors. When conditions worsened, these sectors defaulted, driving up NPL ratios. The soft-pegged monetary system’s instability exacerbated the crisis.

INTEREST RATE MISPRICING AND SECTORAL VULNERABILITIES

Sri Lanka’s elevated non-performing loan (NPL) ratios can be attributed to the mispricing or mis-targeting of interest rates, rooted in a fundamentally flawed central bank (CB) operational regime. The country operates under a highly unstable soft-pegged monetary system, which lacks a clear focus on either interest rate or exchange rate targeting. Instead, the CB attempts to achieve both, leading to policy errors and excess liquidity in the banking system.

When demand for imports increases, creating pressure on the rupee to depreciate, the CB intervenes in the forex market by selling dollars. This reduces the money supply, tightens short-term interest rates, and curbs excessive borrowing. However, to maintain artificially low policy rates, the CB prints money to replenish reserves, negating these effects.

For years, Sri Lankan policymakers have artificially suppressed interest rates, creating mispricing that incentivized lending at unsustainably low rates. This led to over-lending or mal-investment in low-productivity sectors like construction and certain types of MSMEs. When economic conditions worsened or monetary tightening occurred, these over-leveraged sectors faced defaults, exposing vulnerabilities and driving up NPL ratios.

INADEQUATE BANKRUPTCY LAWS

Sri Lanka’s outdated bankruptcy laws fail to address corporate distress effectively. Banks prefer quick recoveries through Parate execution over lengthy court processes. Other mechanisms like creditor compromises rarely succeed. In contrast, countries like the U.S. (Chapter 11) and India (IBC) offer frameworks prioritizing business recovery. Sri Lanka should adopt similar reforms to foster economic resilience and attract investment.

CONCLUSION

Sri Lanka’s MSME sector stands at a critical juncture, grappling with policy missteps, economic turbulence, and systemic weaknesses. While measures like suspending and later lifting Parate executions address immediate challenges, they underscore the need for structural reforms. Sustainable solutions require overhauling monetary and fiscal frameworks, reforming bankruptcy laws, and creating a transparent credit system. By fostering resilience and fair access to resources, Sri Lanka can transform its MSMEs into engines of recovery and sustainable development. The time to act is now.

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