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
Call and repo rates were relatively steady and moved tightly, few basis points above SDFR throughout 3Q. The CBSL remained dovish and cut rates once more to bring the cumulative reduction in interest rates to 250 bps YTD. By allowing average overnight excess liquidity to surge by 35% to LKR 200 Bn from 2Q, the CBSL demonstrated that it would tolerate and maintain unprecedented level of liquidity in the money market to facilitate credit expansion. Stock of treasury holdings of the CBSL was generally maintained around LKR 300 Bn and mainly functioned to smooth out the fluctuations in the money market liquidity level. In this way the CBSL was able to manage the market liquidity with little reliance on daily auctions. In the meanwhile, interbank market volume showed marked decline (51% decline in average call volume from 2Q) while repo volumes swelled back to pre-crisis levels.
Reserve money (i.e. currency in circulation and deposits held by the commercial banks), which is an indicator of economic activity and credit growth, expanded but remained under pre-crisis level. Large foreign currency payments caused abrupt dips in reserve money, which the CBSL generally countered by purchasing treasuries. USD 1,395 Mn foreign currency obligations were pending in 3Q, which would have amounted to a drain of LKR 255 Bn on the money supply, assuming Central Bank sold forex at the market rate.
July rate cut helped to ease T-bill yields but in August and September auctions, some pressure for yields to rise was witnessed. Moody’s two notch downgrade of Sri Lanka’s sovereign ratings to Caa1 on 28th September  intensified the pressure for yields to rise. The GoSL borrowed nearly LKR 344 Bn in 3Q via treasuries as opposed to LKR 221 Bn in the quarter before. As the quantum of treasury securities issued at primary auctions increased, the secondary market activity declined notably during 3Q.
Figure 2: 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
Shorter end of the treasuries, shifted down by around 100 bps subsequent to the policy rate cut in July. Mid and longer tenor yields dropped about 50 bps initially but went through an upward correction over the course of next two months. Subsequent to Moody’s downgrade, bond yields, especially the mid-tenor securities, jumped 10-30 bps immediately, while trading at wider bid-ask spreads.
Figure 3: 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.
Retail lending rates continued to decline throughout 3Q (AWPR ~246 bps, AWNLR ~236 bps, AWLR ~143 bps). 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 indicating improved 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.
Figure 4: Net credit to private and government sectors (M-o-M)
Private credit showed signs of recovery in August after months of contraction. The CBSL set up Saubagya COVID-19 Renaissance Facility to encourage banks to extend credit to COVID hit businesses and individuals. Under this scheme licensed banks had disbursed over LKR 133 Bn fresh loans to distressed entities and individuals by 16th October. Bank credit to the government sector remained strong and far outpaced the private credit expansion.
In line with ICRA Lanka’s previous expectations, a sizable number of corporate borrowers have refinanced their commercial paper borrowings with long-term bank funding lines, to take advantage of the current benign interest rate environment. Thus, the activity level in the commercial paper market has somewhat subdued during the period.
Figure 5: 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
Fed maintained its key benchmark interest rate at 0-0.25% throughout 3Q with the hope of cushioning the impact of COVID-19. Treasury yields rose as the investor optimism bolstered over positive data on US and China economic recoveries. Towards the end August, longer-dated treasury yields increased, as the Fed’s chief, Jeromy Powell announced that the Fed aims to tweak its policy framework to allow for a sustained overshoot of its inflation target. Early September, treasuries struggled to attract funds as US equities turned bullish. However, with the second Corona virus wave raging across Europe, investors returned to treasuries easing yields. In addition, treasuries gained momentum following the worries that US economy was losing impetus.
In this backdrop, Eurodollar rates plateaued towards the end of 3Q. Sri Lanka’s floating rate SLDBs, which are linked to LIBOR USD (6m), had very little interest from investors during the only auction held during 3Q (22nd to 27th July) and several other auctions held before that this year. LIBOR is expected to be phased out by December 31, 2021 and ICRA Lanka in a research note highlighted the weaknesses of the current SLDB fallback language which is not equipped to handle permanent cessation of the reference rate. The link to this report can be found below.
Read ICRA Lanka’s report on the LIBOR Transition
Figure 6: Sovereign bond yields, Sri Lanka vs. Emerging Markets
Notes: Red line – SRILAN 7.550% 28Mar2030, orange line- SRILAN 6.850% 03Nov2025, green line- 6.250% 27Jul2021
The yields on SLISBs continued to improve for good part of 3Q with the strengthening of the external position of the country. However, 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. Nevertheless, the impact on yields was tapered towards the longer-dated bonds, which indicates the investors expect Sri Lanka to experience difficulties in the short to medium term.
Figure 7: External Trade (USD Mn)
Monthly exports remained around USD 1 Bn mark during 3Q 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 up to August in 3Q. In addition, defying earlier expectations, remittances bounced back faster from April. 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. Consequently, the knock-on effect of these production disruptions is expected to adversely affect the export volumes in 4Q.
Figure 8: Net foreign purchase of equities and treasuries (LKR Mn)
Source: CSE, CBSL
Moderate level of capital flight was witnessed in 3Q. Despite bullish local investor sentiment in CSE, the foreign investors continued to exit. July rate cut triggered foreign sellout of treasuries but with improved risk appetite, some foreign capital flew back in September.
Figure 9: Exchange rate
Rupee displayed some volatility in August and September, but overall, appreciated slightly vis-à-vis end of 2Q. Forward market liquidity rose in line with rupee volatility with daily transactions volume averaging over USD 52 Mn by September. Most recent forward market expectations indicate the LKR/USD rate to appreciate to around 184.50/57 by the end 2020. Real Effective Exchange Rate (REER) index, which measures the external competitiveness of the country, declined to 91.73 in August from 92.72 in June.
Figure 10: Gross official reserves (USD Mn)
Weaker dollar, subdued imports, modest export volumes, and recovery of remittances helped to ease pressure off the rupee. Under these circumstances, the CBSL was able to be a net buyer of forex amounting to over USD 310 Mn. The CBSL absorbed USD 100 Mn forex from July SLDB auction and tapped into multiple funding sources – repo facility available for “Foreign and International Monetary Authorities” (USD 1 Bn) and SAARC swap facility (USD 400 Mn) to bolster reserves. With rupee beginning to stabilize, reserve position gradually improved from May to August. GoSL paid down USD 991.2 Mn foreign currency obligations in September which brought the overall reserves down to USD 6.6 Bn. This was followed by USD 1.1 Bn foreign currency payments, including the maturing ISB, in October which would have further shaved off reserves. As of end September, USD 588.2 Mn more foreign currency obligations were pending for the rest of the year.
Figure 11: Government revenue and expenditure (LKR Mn)
|2019 Jan-Jul||2020 Jan-Jul*||Change (%)|
|Total revenue and grants||1,033,008||765,393||-25.9|
Notes: *Provisional data Source: CBSL
Latest data indicates the revenue side of the government plummeting by nearly 26% up to end July 2020 with respect to corresponding period of 2019, while the total expenditure contracted by about 5%. As a result, the fiscal deficit widened by over 27%. The drop in revenue was mainly on account of the drastic contraction of tax revenue (-29%). To counterbalance rapid expansion in recurrent expenditure, the government has cut down capital expenditure by more than 50%.
Figure 12: Outstanding government debt (LKR Mn)
|2019 End Dec||2020 End Jul*||Change (%)|
Notes: *Provisional data Source: CBSL
The government continued to rely on short-term domestic financing, outpacing foreign debt to bridge the fiscal deficit as seen from 31% increase in T-bills issued. Total debt grew by 8% and stood north of LKR 14 Tn of which nearly 46% is foreign debt.
Prices & Wages
Figure 13: CCPI and Wage Rate Index of the informal private sector (Y-o-Y)
Notes: WRI (100=2012), CCPI (100=2013)
Unemployment fell to 5.4% from 5.7%. This faster recovery in the labour market was somewhat unanticipated especially amid dormant leisure sector. Tight revenue conditions have led companies to hold off on wage increments leaving the wage growth subdued. Sub-inflation wage growth eroded the purchasing power of consumers leading to weaker household spending. Proxy indicators such as outstanding credit card balances show nearly 3% decline this year up to August compared to last year.
Though food inflation rose to double digits, low non-food inflation (<1%) resulted in headline inflation being contained around the lower bound of the CBSL’s inflation target (i.e. 4%). Rising food inflation (caused by the supply disruption) and deflationary non-food inflation is an unhealthy combination and could lead to erroneous policy conclusions.
According to the PPI (Producer Price Index), agricultural producers saw the prices increasing by nearly 25% (Y/Y) July to August, while manufacturing producers saw prices increasing by 5%(Y/Y).
Price inflation in real estate slowed down significantly as evident by house prices and land prices decelerating to 0.8%(Q/Q) and 3.5%(Q/Q) respectively in 3Q from 2.2% and 9.9% in 1Q.
Figure 14: ASPI (M/M)
Domestic investors were upbeat post-election and the record performance of ASPI lifted it back to the pre-crisis level fueled by the quest for higher returns in the low interest rate environment. Participation among retail investors rose markedly. Nevertheless, throughout 3Q foreigners were on the sell-side despite attractive valuations. Heavy domestic buying tipped the valuations in favour of sellers as the market PBV (Price-to-book value) rose to 1 by end of 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.
Figure 15: GICS sector performance- 3Q2020
|Sector||Index Points Gain|
|Automobiles & Components||501.34|
|Household & Personal Products||231.73|
|Food Beverage & Tobacco||136.08|
|Health Care Equipment||113.44|
|Commercial & Professional Services||73.9|
|Food & Staples Retailing||41.57|
In 2Q, the performance of the finance & leasing companies (FLCs) worsened, while banks were able to withstand the economic shock. Non-performing assets (NPAs) of FLCs shot up to 14.14% while banks recorded a marginal increase of the same in 2Q. With fast waning asset quality, inflating credit costs dragged down the earnings of FLCs to negative territory. Meanwhile, banks managed to maintain flat earnings. Liquidity levels improved in the banking sector after the release of capital buffers in 1Q. Capital adequacy levels of financial institutions (FIs) especially the FLCs improved amid muted credit growth and rise in investments in T-bills in 2Q.
The banking and finance sectors will continue to be adversely affected by the challenging macro-outlook. ICRA Lanka expects the asset quality indicators to deteriorate further, through 4Q, as the major part of the COVID-19 debt moratorium programme was ending in September. The overall profitability of the sector is affected by both lower credit growth and higher loan loss provisions. In terms of the capital, pressure on capital adequacy has somewhat moderated due to the muted loan growth. However, there are a number of Non-Banking Financial Institution (NBFI’s) still operating below the minimum core capital requirement stipulated by the regulator, which might face pressure going forward.
Figure 16: Financial sector key indicators, % 1Q 2014 – 2Q 2020
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
Figure 17: Crude oil price
Source: Bloomberg quoted in CBSL
Crude oil prices continued to recover in July and August amid optimistic US and China recovery expectations but, slipped in September over heightened uncertainty due to surge in COVID-19 cases across Europe and US. Current prices are beneficial to improve the financials of CPC, but the demand for petroleum products in Sri Lanka was weak (Crude oil imports fell 7% for Jan-Aug period)
Figure 18: Auction prices of commercial crops
Notes: Tea prices for all elevations, rubber prices for LATEX Crepe 4X
Sources: Forbes & Walker, CDA, RRISL
Unfavorable weather contributed to both tea and coconut prices to remain elevated throughout 3Q. Rubber prices began rallying in July on the back of uptick in demand for protective rubber gloves reaching highest YTD prices by end September.
Figure 19: 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
Base metal prices continued to rise on account of China’s recovery and restarting of global industrial activities. Copper prices surged in August and September markedly as world’s largest supplier, South America, was in complete disarray as the Corona virus cases surged.
Gold prices soared in July as low interest rates and global uncertainty compelled investors to seek refuge in gold. 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. In September, bullish stocks triggered gold sell-off but the bleaker global economic outlook that prevailed towards the month end attracted investors back to gold.
Figure 20: Growth of production volumes of key agriculture industries (Y/Y) – 2020
|Month||Tea (%)||Rubber (%)||Coconut (%)||Fisheries(%)|
As indicated by a massive drop in production of key commercial crops and fisheries, agriculture production took successive blows in 1Q and 2Q due to COVID-19 related disruptions (labour deployment issues, agro inputs scarcity, limited market access etc.) and unfavorable weather. With gradual normalization of economic activities, in 3Q the situation improved marginally.
Services & Industries
Figure 21: Economic activity level indicators – 2020 (Y/Y)
|Month||Total electricity usage (%)||Industrial electricity usage (%)||Cement consumption (%)||Ship traffic (%)||Container handling (%)||Cargo handling (%)|
Note: Total electricity usage for September 2020 is an estimated figure
Source: CEB, PUCSL
Most high frequency proxy indicators turned positive in 3Q indicating gradual recovery in services and industrial sectors. Overall electricity consumption, a key indicator of economic activity recovered to pre-crisis level in September. However, on cumulative basis most indicators fell way below corresponding periods of 2019. Industrial electricity usage declined by 10.2% in 7M2020. In addition, for the 8M2020, the total cement consumption contracted by 18.3%. Port services also experienced distinct reduction in activities for the same period, as seen from the decline in ship traffic by 5.5%, container handling by 4.4%, and cargo handling by 4.8%.
Figure 22: 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.
Helped by a strong rebound in exports, manufacturing sector recovered in 3Q. 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, showed a minor recovery in 3Q. The new businesses and business activities improved. 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.
ICRA Lanka revised its initial (published in April) 1Q and 2Q GDP projections down to 0.2% and -6.9% from 1% and -4.5% in August based on its nowcasting models. Official GDP estimate, which was released shortly after ICRA Lanka’s August revision, indicated Sri Lankan economy had contracted by 1.6% in 1Q. The deviation from our initial 1Q forecast was on account of underperformance of the agricultural sector, substantial drop in tax revenue, and higher-than-expected spending by the government on subsidies. In addition, our initial projection had underestimated shock to industrial sector while marginally overestimating the impact on the services sector. All in all, our April 1Q shock estimate is off by about 2%. In light of this revelation, ICRA Lanka recalibrated its nowcasting models. Accordingly, we are revising the 2Q estimate further down to -17.5% (with a margin of error = +/- 16%) and 3Q to -6.1% (with a margin of error = +/- 6%).
The 2nd wave of infections that are currently sweeping across the country, especially in the Western province which accounts for major share of the national output, has significantly dimmed the prospects of faster recovery. The partial lockdowns are expected to disrupt economic activities and the pace of recovery. In this context, spending on subsidies may remain elevated, while it is doubtful that the government would see tax revenue returning to normalcy. Therefore, taking a realistic view and considering the extent of the spread, ICRA Lanka has modelled two scenarios for Sri Lankan economy for 2020 – (1) optimistic case and (2) protracted case as illustrated below.
Figure 23: Potential outcomes for Sri Lankan economy – 2020
|Scenario 1: Optimistic case||Scenario 2: Protracted case|
|Virus spread||Virus is contained within 4Q2020 and economy reopens fully without further interruption.||Situation escalates forces the country into another lockdown in November or December,|
|Overall impact||Moderate||Very high|
|Return to pre-crisis||1Q2021||4Q2021|
|2020 GDP growth||-8.2%||-10.9%|
Source: ICRA Lanka Research
Scenario 2 is modelled assuming the likely sectorial economic shocks to be nearly in line with the likes of 2nd quarter. Scenario 1 is modelled by softening the shocks used for scenario 2. Thus, based on these modelling, our expectation is that the 4th quarter would record a contraction in the range of 7.9 to 17.8%.
ICRA Lanka earlier projected a contraction of 1.9% as the base case and -3.3% as the protracted case for 2020 GDP. With the latest analysis we are revising the annual real GDP growth expectation to -8.2 to -10.9%.
Figure 24: Economic shocks, % (Q/Q) – 2020
Notes: Agr- agricultural sector, Ind+Ser- industries and services sectors, Sub- subsidies
Shocks are deviations from simulated ex-post economic projectiles
Source: ICRA Lanka Research
Figure 25: Evolution of ICRA Lanka quarterly GDP growth projections, %
|4Q2020||-0.9||-7.9 to -17.8|
Source: ICRA Lanka Research
Amidst the challenging outlook, ICRA Lanka has downgraded the issuer ratings of two licensed specialized banks, while a majority of NBFIs remained on Negative Outlook in 3Q. ICRA Lanka will continue to monitor the asset quality indicators of the sector. Post-debt moratorium asset quality and timely completion of planned capital enhancement initiatives for NBFIs will also be a key indicator over the short term.
Life insurance companies were able to achieve top-line growth amidst challenging business outlook, however, the overall profitability was significantly affected by the increase in life insurance liabilities due to the yield curve movement. In terms of the investment activities, life insurance companies were able to book sizable gains on fixed-income investments, due to the declining interest rates during the period.
Primary dealers (PDs) continued to benefit from the favourable interest rate outlook during the period. However, ICRA Lanka expects that opportunities for the PDs to make trading gains will be somewhat limited going forward, as the CBSL signalled a ‘wait and see’ approach by holding policy rates at the last monetary policy committee meeting.
Tea sector remained resilient in 3Q. During this period, Sri Lanka’s tea production was broadly flat from the same period last year, though production for the first nine months of 2020 was sharply down. Buoyant prices due to winter buying and limited global supply improved the profitability of the plantation companies.
The CEB started renewing the expired Power Purchase Agreements (PPAs) for mini-hydro power producers that were under avoided cost basis, during first nine months of 2020. During 3Q, Sri Lanka has experienced rainy weather conditions and therefore, the mini hydropower production of the country has increased due to increased water flows of the runoff river type power plants. However, the trade receivables cycle from the CEB has generally stretched to an extent amidst the weaker macroeconomic condition of the country. 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.
The construction sector experienced a recovery during 3Q 2020 after the lockdowns were lifted. Currently there are large number of rural road development projects underway. In the medium term, these construction projects are expected to incur higher overheads due to COVID-19 related health protocols of the construction sites. In addition, the delays in the payments from the Government to clients still remains a concern. Thus, the construction contractors have faced pressure on the operating profit margin 3Q. Recently, the GoSL has made arrangements for local banks to fund the contractors’ trade payables from the government which would ease the liquidity issue of the contractors to some degree in the short term.
Outlook for 4Q
Based on the current situation of the country, we are projecting a GDP contraction in the range of 7.9 to 17.8% for 4Q. This bleaker outlook could derail the current credit expansion further and weaken aggregate demand. Therefore, we do not rule out the possibility of another policy rate cut before the end of the year. Headline inflation is likely to remain around 4 – 4.5% but the food inflation may remain at upper single digit level. Reserve position is expected to further diminish unless supplemented with sufficient forex inflows. In addition, we expect the exchange rate to remain broadly stable as markets have already factored in most of the shocks. Businesses may scale down operations leading to rise in unemployment and stagnant wages. ICRA Lanka does not expect the exchange rate to experience significant pressure assuming import controls to remain in effect for the rest of 4Q. The factory shutdowns could affect the export volumes moving forward which in turn negatively affect the trade balance. Looking ahead, in this context the government expenditure may remain elevated leading to expansion in the fiscal deficit.
Figure 26: Indicator projections – 4Q 2020
|GDP growth (Q/Q)||-7.9 to -17.8%|
|Policy rates||SDFR – 4% SLFR – 5%|
|Trade deficit (annual)||6.5 to 7%|
|Nominal exchange rate (end 4Q)||184.50/57|
|Fiscal deficit % GDP (annual)||10.6 to 11.4%|
|Unemployment (end 4Q)||6 – 7%|
|Headline inflation CCPI (Avg. 4Q)||4 – 4.5%|
Source: ICRA Lanka Research
 AWPR- Average Weighted Prime Rate, AWNLR – Average Weighted New Lending Rate, AWLR –Average Weighted Lending Rate
 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.
 Calculations are based on Lanka Property Web price indexes.
 However, this figure is somewhat distorted as the loans that qualify for moratorium are being counted out of the NPL category. Hence, the true extent of the NPLs may be higher than the said figure
This publication has been prepared by ICRA Lanka solely for information purposes without regard to any particular user's investment objectives, financial situation, or means. The information in the publication is not an investment recommendation and it is not investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument. Reasonable care has been taken to ensure that this publication is not untrue or misleading when published, but ICRA Lanka does not represent that it is accurate or complete. ICRA Lanka does not accept any liability for any direct, indirect or consequential loss arising from any use of this publication.