Economy at a glance for 2020:Double whammy blow

economy growth

Highlights

  • ICRA Lanka estimates Sri Lanka’s GDP growth rate in 2020 to be -4%. In addition, our estimates indicate industry, services, and agricultural sectors to have contracted by 7.3%, 1.7% and 1.3% respectively.
  • By mid-March the COVID crisis took center stage and the CBSL implemented a series of policy rate cuts further bringing the short-term rates lower to unprecedented levels. As a result, Sri Lanka has seen the lowest long-term rates in years.
  • COVID crisis triggered a panic selling of SLISBs. This resulted in a massive spike in SLISB yields in March accentuated by the country’s external sector vulnerabilities.
  • Following the Moody’s downgrade, the yields on the SLISBs edged up by ~170 to 540 bps which weighed down on country’s ability to raise foreign currency debt.
  • 2020 was a challenging year for the financial sector. It marks a considerably weak performance for NBFIs. However, compared to NBFIs, banking sector was much resilient due to its solid capital buffers.
  • With exports, remittances, and tourist receipts falling to historical lows, rupee was facing immense downward pressure during the first half of the year. In this context, the CBSL introduced import restrictions to bring the situation under control.
  • As per ICRA Lanka’s estimates, the total revenue and grants of the government have plummeted by nearly 28% in 2020, while total expenditure records a marginal increase. As a result, the fiscal deficit may have widened by over 63%. In this context, we expect the total public debt to have reached 97.4% in 2020.
  • With the economic recovery in 3Q, the bourse turned bullish and the record performance of ASPI lifted it back to the pre-crisis level fueled by the quest for higher yield in the low interest rate environment.
  • Oil prices slumped to twenty year low during March and April, due to the initial impact of the pandemic lockdowns across several major economies, but gradually started recovering as the year wore on.
  • Exporters enjoyed robust prices for key export commercial crops tea, rubber and coconut during the year.
  • Price of base metals which are major industrial inputs, declined to their two-year lows in April. On the contrary, onset of the COVID crisis boosted the demand for precious metals, especially gold, as an asset, boosting its prices to historically high levels.

ICRA Lanka Macro Projections 2020-21

201920202021
GDP growth, %2.3-4.03.6
Government revenue, % of GDP12.69.29.6
Government expenditure, % of GDP19.420.320.4
Fiscal deficit, % of GDP-6.8-11.1-10.8
Government debt, % of GDP86.897.499.3
Exports, % of GDP14.212.614.4
Imports, % of GDP23.719.720.5
Trade deficit, % of GDP-9.5-7.1-6.1
Current account, % of GDP-2.1-1.10.2
Annual average inflation (CCPI), Y/Y, %4.34.65.0
Unemployment, %4.85.5 – 6.05.5 – 6.0
Exchange rate (Low), LKR/USD182.9193.1200.0
Exchange rate (High), LKR/USD174.4181.4190.0
Exchange rate (Avg), LKR/USD178.8185.6194.3
Gross official reserves, yearend, USD Bn7.65.73.7
Forex obligations for the year, USD Bn4.26.16.8
AWPR, %9.747.975.50 – 6.00

Interest Rates

Short-term rates

Figure 1: Treasury bill yields and money market rates (weekly averages)

Notes: AWCMR- Average Weighted Call Money Rate, SDFR- Standing Deposit Facility Rate, SLFR- Standing Lending Facility Rate, T-bill yields are for the secondary market, ARR – simple average of daily repo rates

Source: CBSL

Figure 2: Excess liquidity and CBSL’s treasury holdings by month – 2020

Source: CBSL

The CBSL cut the policy rates in end January amidst gloomy global growth outlook. Call and repo rates responded by moving down by about 50 bps but the effect was felt much less in the T-bills market. By mid-March the COVID crisis took center stage and the CBSL implemented a series of rate cuts further bringing the short-term rates lower to unprecedented levels. The move hoped to facilitate credit expansion to COVID hit economy. 

In 3Q more actions followed which included 200 bps reduction of Statutory Reserve Ratio (SRR). The excess liquidity overwhelmed the treasury market and brought the T-bill yields down sharply, resulting in the steepest drop in yields for the year. The CBSL’s balance sheet expanded following the outbreak of the pandemic, and by the end December, treasury holdings were boosted to whopping LKR 700 Bn. Markets flushed with liquidity, forced the overnight rates towards the lower bound of the policy corridor throughout 3Q and 4Q. The banks channeled the excess funds to repo market which resulted in a marked drop in call market volumes while boosting repo volumes to pre-crisis levels during June -September period.

Despite the massive liquidity surplus following COVID relief measures by the CBSL, the T-bill yields displayed some pressure to rise in 3Q and 4Q which left the primary auctions partially filled due to yield caps imposed by the CBSL. Sri Lanka’s sovereign rating downgrades by international rating agencies also intensified the pressure for yields to rise.

Long-term rates

Figure 3: Yield curve of treasuries

Notes: Yields are based on the weekly average that prevailed at the last week of the month, Shorter end – less than 2Y, mid/intermediate tenor – 2 to 10Y, longer tenor – above 10Y

Source: CBSL

The yields on treasuries across the board saw substantial decline of about 250-to-300 bps in 2020 compared to end 2019. Subsequent to Moody’s downgrade, bond yields, especially the mid-tenor securities, jumped 10-to-30 bps immediately, while trading at wider bid-ask spreads. With the advent of the second wave of infections, the yields continued to rise for next two months. In this backdrop, there was a significant decline in transaction volumes in T-bonds in 4Q.  

Figure 4: Secondary market T-bill yields and AWPR

Note: AWPR is calculated based on the submissions made by the commercial banks to the CBSL on the rates offered to customers who borrowed more than LKR 10 Mn for less than three months.

Source: CBSL

AWPR[1] remained at upper single digit levels and continued to steadily decline (~130 bps) throughout 1H amidst monetary easing. Retail lending rates continued to decline throughout 3Q (AWPR ~246 bps, AWNLR ~236 bps, AWLR ~143 bps)[2]. The spread between AWPR and 3M T-bills historically had remained above 200 bps. Facilitated by the July policy rate cut, the spread shrunk to under 200 bps by September and continued to decline indicating improving risk appetite of lending institutions. Taking a targeted approach, the CBSL decided to slap caps on interest rates on credit cards, pre-arranged temporary overdrafts and pawning facilities in August. 

Credit

Figure 5: Net credit to private and government sectors, (M/M)

Source: CBSL

Credit growth was recovered following the January rate cut by the CBSL, but quickly lost momentum with the pandemic outbreak. In order to facilitate credit flow to the economy to speed up recovery, the CBSL implemented several measures including successive rate cuts, but the private credit contracted for three months. With the partial lifting of the lockdown, from August onwards, the credit started picking up to year ago levels (4.2% Y/Y). The government credit expansion remained strong throughout the year (11.1% Y/Y).

International rates

Figure 6: International lending rates

Notes: The SOFR Averages are compounded averages of the SOFR over rolling 180-calendar day periods. Fed started publishing SOFR term rates from March onwards.

Source: New York Federal Reserve and global-rates.com

The global growth outlook was already overshadowed by the deteriorating US-China trade relations at the beginning of 2020. The situation was worsened by the rapid spread of COVID-19 virus across China and the developed countries. The Central Banks, including the Fed, dropped the interest rates to rock bottom which led to a gradual decline of Eurodollar rates for the most part of 2020.

Figure 7: Sovereign bond yields, Sri Lanka, nearest vs. longest maturity

Source: CBSL

COVID crisis triggered a panic selling of SLISBs. This resulted in a massive spike in SLISB yields in March accentuated by the country’s external sector vulnerabilities. Afterwards, yields went through a correction phase for good part of 3Q with the strengthening of the external position of the country. Following the Moody’s downgrade, the yields on the SLISBs edged up sharper by ~170-to-540 bps which weighed down on country’s ability to raise foreign currency debt. In 4Q, the situation was further aggravated by the country succumbing to the second wave of infections, however, yields on ISBs started to moderate in November as investors reevaluated their initial reaction to the second wave. Yields once again gradually climbed up during December over Sri Lanka’s long-term sovereign credit ratings being downgraded by Fitch and S&P.

External Sector

Figure 8: External Trade (USD Mn)

Sources: CBSL

With exports, remittances, and tourist receipts falling to historical lows, rupee was facing immense downward pressure during the first half of the year. The CBSL introduced import controls in March to curb forex outflows. In May, the exports started to recover and by June bounced back closer to pre-crisis level driven by decent performance of tea and apparel exports. Country achieved a trade surplus in June amidst subdued import growth. The worker remittances also made a recovery in May and in June surpassing the pre-crisis level. Throughout 3Q, monthly exports remained around USD 1 Bn led by the apparels and commercial crops. Better-than-expected performance of exports together with import controls contributed to a noteworthy improvement in trade deficit. However, after a critical industrial zone in Western province became the epicenter of Sri Lanka’s second wave of infections, several industrial plants were shutdown to contain the spread, leading to notable reduction in export volumes. In 2020 we expect the trade deficit to improve significantly to 7.1% of the GDP. Reduction in trade deficit has also contributed to a noteworthy improvement in current account balance, which we expect to around -1.1% of the GDP.

Figure 9: Net foreign purchase of equities and treasuries (LKR Mn)

Source: CSE, CBSL

Pandemic worries and interest rate cuts caused the capital to flow out of treasury and equity markets especially during March. ICRA Lanka’s estimates show around USD 800 Mn outflows on net basis for 2020. Despite bullish local investor sentiment in CSE, the foreign investors continued to exit.

Figure 10: Exchange rate

Source: CBSL

Exchange rate remained broadly stable during1Q but once the COVID crisis overwhelmed the economy, rupee depreciated sharply close to LKR 200/USD. The import controls and intervention by the Central Bank brought the situation under control, but in December rupee displayed some volatility and pressure to depreciate.

Latest available data indicates, the Real Effective Exchange Rate (REER)[3] index, which measures the external competitiveness of the country, has increased to 91 in November compared to 90 which prevailed during the beginning of the year.

Figure 11: Gross official reserves (USD Mn)

Source: CBSL

During 2020, Sri Lanka lost one-fourth of its reserves. In addition, for 2020, over USD 6 Bn foreign currency obligations were pending including USD 1 Bn ISB in October. SLDB auctions, Fed repo facility and SAARC swap facility were used to bolster reserves. Weaker dollar, subdued imports, modest export volumes, and recovery of remittances helped to ease pressure off the rupee and keep the intervention at a lower level. Under these circumstances, the CBSL was able to be a net buyer of forex amounting to over USD 280 Mn. In addition, the CBSL sold down about USD 234 Mn gold reserves amidst favorable gold prices to boost reserves in June.

Fiscal Sector

Figure 12: Government revenue and expenditure (LKR Bn)

20192020*Change (%)
Total revenue and grants1,8991,374-27.6
Total expenditure2,9153,0354.1
Deficit1,0161,66163.4

Notes: *ICRA Lanka projections                                                                              

Source: CBSL

As per ICRA Lanka estimates, the total revenue and grants of the government plummeted by nearly 28% in 2020. Tax revenue alone have gone down by over 30%. Total expenditure records only a marginal increase as the surge in recurrent expenditure was counterbalanced by dramatic reduction in capital expenditure. Consequently, the fiscal deficit was widened by over 63%.

Figure 13: Outstanding government debt (LKR Bn)

End 2019End 2020*Change (%)
Total debt13,03114,59512.0

Notes: *ICRA Lanka projections                                                                              

Source: CBSL

The rupee value of foreign debt recorded a marginal decline. Domestic debt, which was increased by nearly 25%, was mainly financed using T-bills. ICRA Lanka estimates show total outstanding government debt increasing by 12% to LKR 14.6 Tn during the 2020. We expect the total public debt to have reached 97.4% of the GDP in 2020.

Prices & Wages

Figure 14: CCPI and Wage Rate Index of the informal private sector, (Y/Y)

Notes: WRI (100=2012), CCPI (100=2013)

Source: CBSL

In 2Q unemployment fell to 5.4% from 5.7%. This faster recovery in the labour market was somewhat unanticipated especially amid dormant leisure sector. The wage growth continued to remain weak throughout the 2H with the exception of September where the economy made a slight recovery before being hit by the second wave.

Purchasing power of the consumers also remained weak as seen by proxy indicators such as outstanding credit card balances which show nearly a 4.8% decline this year up to November. Tax cuts announced in November 2019 contributed to decline in non-food inflation in early 2020 before the COVID outbreak, as a result of downward adjustment of prices of services related items (telco, health, airfare, internet etc.). Even though inflation remained around 4% since May, the food-inflation continued to be around upper single digits due to supply shocks. Non-food inflation was mild, and was under 1% for August and September months.

According to the PPI (Producer Price Index), agricultural producers saw the prices increasing by double digits on year-on-year basis following the outbreak averaging 22.2% from May to November, while manufacturing producers saw prices increasing by 4.4%(Y/Y) for the same period.

Price inflation in real estate sector eased in the 1H (Land 10%, houses 2% Q/Q basis by end 2Q) but as the credit recovered land and house prices accelerated in the second half (Land 17%, houses 20% Q/Q basis by end 4Q)[4].


[1] AWPR is calculated based on the submissions made by the commercial banks to the CBSL on the rates offered to customers who borrowed more than LKR 10 Mn for less than three months.

[2] AWPR- Average Weighted Prime Rate, AWNLR – Average Weighted New Lending Rate, AWLR –Average Weighted Lending Rate

[3] A rising REER typically means that a country’s goods are becoming more expensive to foreign counterparts, and therefore less competitive (i.e. stronger rupee), relative to its trading partners while a declining REER indicates the opposite.

[4] Calculations are based on Lanka Property Web price indexes.

Equities

Figure 15: ASPI (M/M)

Note: CSE was not operational for the whole month of April

Source: CSE

The CSE operated with bearish sentiment throughout the first two months of 2020 as Corona virus fears loomed across East Asia. With the first local Corona patient reported in March, the CSE immediately went into free-fall. The trading at the CSE was suspended several times during March due to intraday crashes. To prevent further collapse, the market operations were suspended for the entire month of April. In subsequent months the market made a modest recovery as investors start buying undervalued stocks.

Economic recovery in 3Q turned bourse bullish and the record performance of ASPI lifted it back to the pre-crisis level fueled by the quest for higher yield in the low interest rate environment. Heavy buying interest was seen among the retail investors. Nevertheless, throughout the year foreigners were on the sell-side despite attractive valuations. The second wave of infections had a blow on the market sentiment in early 4Q but the prospects of viable vaccines helped to turn it around.

Essential sectors and utilities such as pharma, healthcare, power, energy, and telecom had the least impact on their valuations. Export oriented sectors such as textile and manufacturing had moderate impact, but plantations, which comprised mostly of tea exporters had fairly a good run during the 2Q due to rise in global tea prices. Due to restrictions in mobility and social distancing, sectors such as construction, real estate, leisure and services were also moderately affected. Import dependent sectors such as trading and motor vehicles and financial sector equities such as banks, finance & leasing, and investment funds were the hardest hit. Palm oils companies reported a deep dent in their share values in 1H 2020.

In 3Q, nearly all GICS sectors made gains. Shipping, logistics, and tyre industry shares saw the largest gains for the quarter. In addition, construction related stocks such as cement and glass also gained. Increasing economic activities fuelled buying interest for energy, utilities, retail and consumer products shares. In 4Q, all GICS sectors recorded gains except bank and real estate shares. Transport sector shares recording exceptional performance.

Figure 16: GICS sector performance- 2020

SectorIndex Points Gain
Transportation4,002.59
Materials670.24
Automobiles & Components494.64
Health Care Equipment488.14
Household & Personal Products272.85
Utilities259.64
Retailing253.19
Energy166.27
Consumer Durable129.21
Capital Goods124.27
Food Beverage & Tobacco92.10
Commercial & Professional Services58.09
Food & Staples Retailing35.49
Insurance23.67
Telecommunication21.65
Consumer Service2.77
Real Estate-16.68
Diversified Financials-70.10
Banks-113.44

Source: CSE

Financial Sector

Financial sector was among the most affected in 2020. Credit demand plummeted at the onset of the pandemic and remained subdued for two quarters. The CBSL’s COVID response included slew of measures to facilitate credit to revive the economy and ensure adequate liquidity in the financial system. These actions include policy rate cuts, releasing capital and liquidity buffers, relaxing administrative and supervisory compliance requirements, and implementing a debt moratorium.

Banks

Compared to NBFIs, banking sector was much resilient due to its solid capital buffers. Return on Assets (ROA) were low. Net Interest Margin (NIM) of the banking sector deteriorated to around 4% in 3Q on account of interest rate cuts, debt moratorium, and lower credit growth. Import restrictions shaved off some of the income due to unutilized credit lines for imports and reduction in fee base income. However, banks benefited from reduction in operational costs as a result of partial deployment of workforce, limited branch operations, permanent closure of certain branches, and frozen recruitments. Banks maintained comfortable level of capital and liquidity while the credit grew in double digits in the first 3 quarters. NPAs slid marginally. By 15th October 2020, under the Saubagya Renaissance Facility, around LKR 178 Bn loans were approved. There was a slight up-tick in Non-performing Assets (NPAs) in 2Q but, in 3Q due to the impact of moratorium, Construction and retail were among the most affected sectors which the banks had substantial exposure to.

NBFIs

2020 marks a considerably weak performance for NBFIs. Annualized Return on Assets declined to -2.31% for 3Q. The NBFI sector recorded five consecutive quarters of negative credit growth from 3Q 2019 which has resulted in a substantial decline in total assets. Consequently, there was a significant improvement in capital adequacy level (i.e. Core Capital to Risk Weighted Assets) in 2Q and 3Q.

As of March 2020, a large number of small-medium sized finance companies were operating below the minimum core capital requirement stipulated by the CBSL and all these entities were undergoing capital enhancement initiatives. This vulnerability played a significant role in weakening the resilience of the NBFIs. The asset quality continued to deteriorate as seen from high level of NPAs (i.e. Gross Non-Performing Advances to Total Advances). Though moratorium helped to moderate the NPAs in 3Q, waning asset quality caused the credit cost to rise. With the release of capital buffers, the liquidity levels (i.e. Regulatory Liquid Assets to Total Assets) showed a marginal increase. Some of the loss-making Licensed Finance Companies (LFCs) have been forced to shut down, or adhere to the consolidation plan set out by the CBSL where they are obligated to merge with profitable LFCs. The biggest hit the revenues of the NBFIs came as a result of the import ban on new vehicles set by the government. But on the other hand, this has led to an increase in lending to the secondary vehicle market. The rise in the value of existing motor vehicles had a positive effect on the collateral position of these companies, however its effect has been curtailed by the repossession ban set out by the CBSL. Funding profiles of Sri Lanka’s finance companies have been largely characterized by limited diversity, with fixed deposits dominating the funding profile. It was earlier expected that deposit base of the finance companies would erode amidst the pandemic. Nevertheless, the depositors opted to maintain their cash with the finance companies as the opportunity cost of withdrawals far outweigh the low interest rate on the bank deposits. Recoveries of trishaw and services sector performed considerably better than anticipated while tourism related lending continued to experience delays in recoveries.

Figure 17: Financial sector key indicators, %

Notes: Capital adequacy indicators; for banks- Tier 1 Capital Ratio, for finance/leasing companies – Core Capital to Risk Weighted Assets, Earnings indicators; for banks- Return on Assets – before tax, for finance/leasing companies – Return on Assets (Annualized), Asset quality indicators; for banks- Non-performing Loans to Total Loans and Advances, for finance/leasing companies – Gross Non Performing Advances to Total Advances, Liquidity indicators; for banks- Liquid Assets to Total Assets, for Finance/leasing – Regulatory Liquid Assets to Total Assets

Source: CBSL

Commodities

Figure 18: Crude oil price

Source: Bloomberg quoted in CBSL

Oil prices slumped to twenty year low during March and April, due to the initial impact of the pandemic lockdown across several major economies. Optimism regarding US and China recovery along with the easing of lookdown restrictions in many countries caused demand for oil to somewhat recover during July and August. Prices slumped again during September and October as a result of the resurgence in COVID cases. However, prices rebounded towards the end of the year due to vaccine optimism, confirmation of congress relief bill as well as Brexit trade agreement. Milder crude oil prices that prevailed during the height of the crisis and months following, greatly helped to bring down the trade deficit for Sri Lanka and improve the balance sheet of Ceypetco.

Figure 19: Auction prices of commercial crops

Notes: Tea prices for all elevations, rubber prices for LATEX Crepe 4X

Sources: Forbes & Walker, CDA, RRISL

Adverse weather conditions coupled with labor shortages due to COVID19 restrictions resulted in a marked rise in tea prices during the first half of the year. Nevertheless, the demand remained robust due to weaker rupee. The second wave of the pandemic, caused further price hikes during October and November but eventually edged lower during December as buyers rushed in to buy stocks before market closure.

Global rubber demand fell by 15.7%, causing prices to fall during the first half of the year. This was partly affected by the 20% decline in demand from China, which accounts for 40% of total global consumption.  Subsequently, the re-commencement in China’s auto production accompanied by an increased demand for medical gloves during 3Q triggered a sharp rise in global rubber prices. Eventually, prices declined during December amidst weakening demand.

Coconut production continued to be affected by the unfavorable weather thereby driving the prices higher for the most part of 2020. CDA suspended coconut auctions from 30th September indefinitely as coconut prices soared due to supply shock.

Figure 20: Metal price index (2016=100)

Notes: Base metals index includes Aluminum, Cobalt, Copper, Iron Ore, Molybdenum, Nickel, Tin, Uranium, and Zinc, precious metals index includes Gold, Silver, Palladium, and Platinum

Source: IMF

Price of Base metals, which are major industrial inputs, declined to their two-year lows in April due to COVID disruptions. Prices started to recover on account of China’s recovery during the subsequent months. Copper prices surged in August and September as the world’s largest supplier, South America, was in complete disarray as the Corona virus cases surged. Subsequently, vaccine announcements caused prices to soar higher towards the end of the year.

Onset of the COVID crisis boosted the demand for precious metals, especially Gold, as an asset class. Gold price has reached historicaly high levels during the year. But in August, rise in US treasury in the first half of August sparked investors to sell gold halting months long rally. Gold rebounded later in the same month over weaker dollar and expectations of inflation to stay above 2% as Fed announced its new approach to monetary policy. Prices remained relatively stable during 3Q, however plunged towards the end of the year as vaccine optimism turned investors bullish before gaining back as the second wave of infections rose across US and Europe.

Real Sector

Agriculture

Figure 21: Growth of production volumes of key agriculture sectors – 2020, (Y/Y)

MonthTea (%)Rubber (%)Coconut (%)Fisheries (%)
Jan-5.6-6.8-3.01.5
Feb-17.1-5.7-10.2-5.9
Mar-52.8-13.9-23.4-25.5
Apr-14.0-20.8-20.6-41.5
May-16.7-6.2-17.3-41.4
Jun-1.5-7.6-2.8-33.4
Jul4.00.0-5.1-6.2
Aug-14.221.6-6.5-0.5
Sep016.8-1.6-12.8
Oct10.311.5-8.2-24.4
Nov3.38.4-3.6-14.4

Source: CBSL

The data shows a massive setback in the overall production level of the agricultural sector triggered by the adverse weather condition and Corona induced disruptions. Coconut production has a marked decline and has been falling throughout the year. Rubber production fell in the first half of the year but made a strong rebound in 3Q. During 1Q, the tea production fell dramatically but was mostly recovering from July onwards. Fisheries sector also suffered major blows during the height of first and second waves.

Services & Industries

Figure 22: Economic activity level indicators – 2020, (Y/Y)

MonthTotal electricity usage (%)Industrial electricity usage (%)Cement consumption (%)Ship traffic (%)Container handling (%)Cargo handling (%)
Jan5.42.8-12.72.74.14.1
Feb9.25.19.37.53.94.0
Mar-7.2-26.9-42.1-5.4-5.2-5.4
Apr-15.5-42.9-55.9-15.9-25.2-28.2
May-12.2-15.4-63.2-17.5-19.3-24.2
Jun-5.0-1.742.6-13.7-9.7-14.2
Jul-1.52.110.4-0.85.76.1
Aug-1.5-4.117.4-10.00.25.3
Sep0.65.81.62.66.68.8
Oct2.4-1.229.9-4.4-1.64.2
NovN/AN/A0.6-23.3-9.2-5.8

Source: CBSL

The economic activity levels were extremely subdued during March to June period. Most high frequency proxy indicators turned positive in 3Q indicating gradual recovery in services and industrial sectors.

Figure 23: PMI deviation from point of neutrality, Index points

Notes- negative values indicate sector is generally contracting on a month-on-month basis while positive values indicate the sector is expanding. The strength of contraction or expansion is manifested by the magnitude of the figure.

Source: CBSL

Weaker manufacturing outlook that prevailed owing to slowdown in order books and supply disruptions in the first two months of the year, exacerbated with the domestic lockdowns imposed in mid-March. In April the sector underwent a record contraction as the country went into a lockdown. Businesses quickly scaled down the operations to cut costs. Apparel manufacturers continued to experience low orders from key export markets. In addition, the lead-times of manufacturers lengthened due to delays in inbound shipments and local logistics.

Tourist arrivals declined in the first two months of 2020 over Corona virus disruptions. This hurt the activities in the services sector to a greater extent. Following the lockdown in March, tourism came to a grinding halt causing a severe drop in revenues in the leisure sector.  Trade sector was also affected due to import restrictions and exchange rate depreciation. Moreover, the disruption to delivery and distribution channels also affected trade activities.

With the lifting of the lockdown, the economic activities normalized to some degree helping the production activities in the manufacturing sector. Employers were seen reinstating some of the jobs they previously cut. The order books showed improvement. With greater mobility following the lockdown, trade and transportation sectors saw business activities picking up. Employment in troubled leisure and tourism sectors were seen contracting for yet another month. Backlogs started to deescalate as business were returning to normalcy.

Helped by a strong rebound in exports, manufacturing sector recovered in 2H. It was characterized by rehiring of workforce, raw material stockpiling, increase in production levels, and active orderbook. However, the supply chain disruption was widely prevalent.

With normalization of day-to-day life, services sector, also showed a minor recovery in 2H. However, the sector kept shedding workforce in order to stay afloat amid weaker revenue streams. During the period, backlogs started to fade while the expectation for future activities improved.

GDP

Figure 24: GDP growth – 2020 (Q/Q), %

1Q2Q3Q4Q*Sector GDP*
Agriculture-6.2-5.94.3-2.0-1.3
Industry-7.8-23.10.6-4.0-7.3
Services3.1-12.92.1-3.0-1.7
Quarterly GDP-1.7-16.31.5-4.1-4.0

Note: *based on ICRA Lanka estimates

Sources: DCS, ICRA Lanka Research

ICRA Lanka’s previous quarterly GDP growth rates projections indicated the 2Q to be -17.5% and 3Q to be -6.1% of which 2Q data is quite close and well within the margin of error to the official data released shortly afterward ICRA Lanka’s release. As for 3Q data, official data falls outside the margin of error of the ICRA Lanka’s predicted value, a likely result of a significant structural change in the economy due to COVID crisis. Furthermore, the economy seemed to have coped with the second wave considerably well. Hence, we revised up our earlier projection (optimistic case) for 4Q from -11% to -4.1%. In light of this, the 2020 GDP growth rate is estimated to be -4%, a stark improvement against earlier expectation of -8.2% (optimistic case). In addition, our GDP estimates indicate industry, services, and agriculture sectors to have contracted by 7.3%, 1.7% and 1.3% respectively.

Ratings Commentary

Financial Sector

The calendar year 2020 was a perfect storm for the banking and NBFI sector, as the industry was affected from multiple fronts. Credit growth was muted during the period, while the financial institutions were cautious about their exposures. Lower credit growth and the COVID-19 debt moratorium affected the core lending margins for financial institutions, while the overall profitability was further affected by the higher credit cost (i.e. loan impairment costs). Asset quality indicators deteriorated sharply, where the peak NPA numbers were witnessed during mid-2020. From the capital side, most of the planned capital raising initiatives, especially by NBFIs, got adversely affected by the uncertain macro-outlook. In this context, ICRA Lanka downgraded the issuer rating one licensed specialized bank and two NBFI. Outlook for most of the NBFIs remained negative.

The life insurance sector was adversely affected by the sharp decline in systemic interest rates, where the insurers saw a sizable increase in life insurance liabilities due to the repricing effect. This resulted in significant unrealized losses for life insurance companies, in turn affecting their overall profitability and capital buffers.  However, business-wise the sector showed resilience during the pandemic affected economic climate. ICRA Lanka has not taken any rating actions in the life insurance sector, during the 2020.

Primary dealers (PDs) gained significantly during the year 2020, as the sharp decline in interest rates resulted in sizable trading gains for the PDs. Asset quality of the sector is not affected as the PDs exposures are only towards treasury backed asset classes. ICRA Lanka upgraded the issuer rating of one primary dealer.

The mutual fund and asset management sector also performed well during 2020, as the asset management sector saw a sharp increase in AUM (asset under management) due to the historically low interest rates offered by the banks and NBFIs.

Corporate Sector

The hydropower sector displayed healthy financial profile during 2020 which is characterized by robust profitability, moderate capital structure and more than adequate coverage metrics. The profit margins of mini hydropower producers received a boost with the GoSL’s approvals on the new tariff structure for expired Power Purchase Agreements (PPAs) that were under the avoided cost tariff system. In addition, this step helped to recover outstanding trade receivables from these older PPAs at a favorable tariff rates. With high rainfall in 3Q, power generation by the mini hydropower producers rose further helping the revenues. But the longer payment cycles of the CEB, forced the mini hydro producers to run with increased working capital intensity.

Private health sector faced a challenging year in 2020 due to the pandemic. This was exacerbated by the already saturated market and industry regulations. Rising wage cost was also contributing to cost escalations. Price increases by private healthcare service providers helped to mitigate the impact to a certain degree.

Tea sector remained resilient in the 2H. Buoyant prices due to limited global supply improved the profitability of the plantation companies. During the first six months Sri Lanka’s tea production was down from the last year, though production for the first nine months of 2020 was sharply down. Tea brokering business also recorded moderate financial performance in 2020.

The construction sector experienced a slowdown in the overall order books and faced operating profit margin pressure in 2Q before starting to recover in 3Q. Brief period of exchange rate volatility in April caused strain on the profitability. The construction contractors have faced pressure on the operating profit margin in 3Q due to delays in trade receivables from the government. However, after the GoSL has made arrangements for local banks to fund the contractors’ trade payables from the government, the liquidity pressure was eased somewhat. Gearing levels and working capital levels were seen increasing among the ICRA Lanka rated construction entities.

During early 2020, the government had decided to procure the electrical cable requirements for CEB from the local cable manufacturers. This has helped the local cable manufacturers to improve their profitability levels.

Consumer durables though affected during 2Q, volumes improved due to pent-up demand following the lockdown and demonstrated better-than-expected resilience.

The export sector, especially for perishable products such as horticulture, tissue culture, vegetables and etc. have suffered from lower revenue growth. However, the export-oriented manufacturing items such as gloves, purifications, protective clothes had a robust cash flow and have performed exceptionally well in 2020.

Outlook for 2021

The World Bank forecasts global economy to expand by 4% in 2021 while the IMF projects a more optimistic figure, 5.5%. Global Outlook

Global economic outlook for 2021 is expected to rebound with the successful vaccine rollouts in major economies supported by accommodative fiscal, financial and monetary conditions. The World Bank forecasts global economy to expand by 4% in 2021 while the IMF projects a more optimistic figure, 5.5%. The level of recovery is likely to be uneven across countries. According to IMF, emerging and developing countries are projected to grow at around 6.3% while advanced economies to grow around 4.3%. Global trade volumes are forecasted to rebound to around 8%, where tradable sector is expected to recover faster than non-tradable sector. Global inflation is expected to remain subdued through 2022. The pandemic has significantly increased economic vulnerability of frontier economies and sluggish growth will further weaken the debt serviceability of these countries.

Figure 25: Vaccine timeline by country

Notes: Countries by when they are expected to have vaccinated 60-70% of their adult population against COVID-19

Source: Graphic developed by Statista based on Economist Intelligence Unit

Global recovery is predicated on how fast the countries vaccinate their population. US, Europe, and some Scandinavian countries are among the countries with the fastest rollout of inoculation programmes. Sri Lanka is expected to vaccinate 60-70% its population by early 2023. India and China, two of the key trading partners of Sri Lanka, are expected to reach the 60-70% milestone by late 2022.

GDP

Figure 26: Annual GDP growth projections, 2020–25, %

202020212022202320242025
GDP-4.03.64.03.83.93.8

Source: ICRA Lanka Research

Shocks created by COVID in 2020 is expected to reverberate for another 8 or more quarters, and the phase out of the pandemic will take place in a span of another year or two according to some experts. Thus, it is less likely that the economy will return to full employment in 2021. The growth will be subdued for next few years in the absence of significant investments and improvements in technology. Therefore, we expect economic growth of Sri Lanka to be around 3.6% in 2021 and hover around 4% for next four years thereafter.

External Sector

Figure 27: Key trading partner growth outlook – 2021

Notes: China figure is for annual GDP growth

Sources: (a)The Conference Board, (b) ECB, (c) ICRA, (d) Deloitte, (e) World Bank, (f) Goldman Sachs, (g) Bank of England

US, Europe, UK, India, and China have high significance when it comes to international trade from Sri Lankan standpoint. Sri Lanka’s largest export destination – United States (USD 3.1 Bn exports in 2019), is expected to recover to pre-crisis level by 2021 2Q, while Europe’s (USD 2.2 Bn in 2019) and the UK’s (USD 998 Mn in 2019) recovery is expected much later, in 2022. China, which is the main source market for industrial inputs (total import value of USD 4 Bn in 2019), has already past the pre-crisis level while India’s (USD 3.8 Bn) recovery is expected much later. Due to these reasons, we do not expect the export sector to normalize in 2021. In other words, we expect the exports to grow at a slower rate than its potential in the 2H. As for non-tradable sector, especially the tourism sector, will likely to go through another tough year in 2021. Therefore, the tourism earnings will see further collapse in 2021.

Unlike exports, imports are clipped by the import restrictions. Therefore, imports are expected to be more or less flat throughout 2021. But we believe it is likely that the government may ultimately be compelled to relax the restrictions, at least partially, in 4Q. Nevertheless, the import restrictions would increase the trade deficit to about 6.1% of the GDP while generating a current account surplus of about 0.5% of the GDP. Rising commodity prices also have a bearing on the trade balance. Increasing oil, and industrial and agricultural inputs will also likely to inflate the import bill of the country more so than the value of exports (expected price increases of export commodities and finished goods are relatively mild) causing terms-of-trade to deteriorate further.

It is very likely that the financial (capital) account continued to be restricted. Remittances are likely to remain flat for 2021. Net outflows from G-secs and equities would also remain low. In this context, fluctuations in the trade deficit are likely to be the main determinant of the exchange rate assuming all export proceeds are converted to rupees. We expect significant pressure to depreciate in May, November, and December months on account of relatively weaker current account balances. During these months the exchange rate may depreciate as low as 200 LKR/USD, but the on other months the rate in general may hover around 195 LKR/USD.

Foreign currency obligations for 2021 is just over USD 6 Bn. This includes settlement of USD 1 Bn ISB maturing in July. We expect the GoSL to rollover about USD 2 Bn existing obligations, borrow about USD 2.3 Bn of which USD 2 Bn may come from a bilateral arrangement with China. In addition, FDIs may remain low around USD 200 Mn. As per ICRA Lanka’s projections, with the positive current account balance and additional forex borrowings the total reserves would fall to USD 3.7 Bn by the end of 2021.

Fiscal Sector

On the fiscal front, we expect the government revenue to gradually return to normalcy by the 2H. The expenditure side of the government may expand at a steady pace throughout 2021. The budget estimate put forth by the GoSL hopes to spend about LKR 3.5 Tn, while the revenue side is expected to be over LKR 2.0 Tn. Given the fragile state of the economy and the revenue loss from import controls, we doubt that the government would be able to meet this revenue target. Hence, we project the revenue would fall short by about LKR 450 Bn from the envisaged level. The GoSL plans to spend about LKR 1 Bn in capital expenditure (investments) in 2021. But we expect the government to scale these down to about LKR 850 Bn and as a result we expect the total expenditure to be LKR 140 Bn less than what is mentioned in the budget estimates. According to our projections, the budget deficit would reach 10.8% of the GDP in 2021.

The government’s fiscal policy is now closely aligned with Modern Monetary Theory (MMT). This means we can expect the treasury to rely less on the market borrowings while lean more towards financing spending via short-term direct borrowings from the Central Bank. In the meanwhile, impaired access to foreign markets may bring down the foreign currency denominated debt. Total stock of debt will exceed LKR 16.3 Tn and expected to reach 99.3% of the GDP.

With the gradual pick up of aggregate demand along with constrained supply and lower production levels, the prices will move up in 2H. Inflation

Inflation level is expected to be subdued in 1H as a result of the combined effect of high food inflation and low non-food inflation. But with the gradual pick up of aggregate demand along with constrained supply (due to import restriction) and lower production levels, the prices will move up in 2H. However, we feel the CCPI (Y/Y) inflation will be contained well within 4-to-6%.

Interest Rates

The CBSL, in its 2021 road map indicated that it is committed to maintaining single digit interest rate throughout the year. Hence, we do not expect the CBSL to carry out changes to current policy rate. With this the interest rates are expected to stabilize. We expect the AWPR to fluctuate between 5.50-to-6% for the year.

Commodities

Figure 28: Key commodity price predictions

CommodityUnit20202021Change (%)
Crude oil, averageUSD/bbl41.044.07.3
Tea, averageUSD/kg2.752.770.7
Coconut oilUSD/mt9309370.8
Rice, Thailand, 5%USD/mt500498-0.4
Wheat, US, HRWUSD/mt2052071.0
ShrimpUSD/kg12.7512.870.9
Sugar, WorldUSD/kg0.280.293.6
Rubber, RSS3USD/mt1.621.683.7
DAPUSD/mt3103182.6
Phosphate rockUSD/mt75784.0
Potassium chlorideUSD/mt2202283.6
TSPUSD/mt2602683.1
Urea, E. EuropeUSD/mt2302362.6
AluminiumUSD/mt1,6601,6801.2
CopperUSD/mt6,0506,3004.1
Iron oreUSD/dmt107.0105.0-1.9

Source: World Bank

Commodity prices will rebound in 2021 with surge in aggregate demand. Crude oil, which takes a sizable portion of Sri Lanka’s imports bill, is projected to rise over 7% in 2021. In addition, major industrial and agricultural inputs are expected to rise by 3-to-4% in 2021. Out of the key export commodities, only rubber prices are expected to maintain the momentum.