Hit by successive blows from 2018 political crisis and Easter Attacks, Sri Lanka’s GDP growth in 2019 (2.7% according to IMF and ADB) is expected to be the lowest since 2001. In 3Q the economy saw signs of recovery with industry and service sectors gathering impetus but the growth is expected to be less than 3% in 4Q. Following the Presidential Election, the economic activities revived briefly driven by the positive sentiments. However, performance of the agriculture sector continued to remain muted owing to adverse weather conditions. Export sector did not experience appreciable improvement over the months in comparison to 2018 but imports shrunk notably causing trade gap to narrow. The Central Bank of Sri Lanka (CBSL) made significant intervention to bring the interest rates down. As a result, there is marked drop in short-term and longterm interest rates. Yield curve showed a significant downward shift from the year beginning. Liquidity shortage that prevailed in the beginning of the year led to a private credit crunch. After several liquidity injections by the CBSL, the liquidity improved causing the credit demand to pick up. Exchange rate showed several positive swings time to time but was mostly depreciating.
By the year end, the CBSL maintained rupee at about LKR 181/USD, marginally stronger compared to the beginning of the year. Reserve position improved owing to successful issuances of International Sovereign Bonds (ISBs) and Extended Fund Facility (EFF) and we expect the gross official reserves to cross USD 7Bn by December 2019. Inflation rate in the economy was moderate in 2019 and was well within the bounds of CBSL’s targets, but accelerated towards the end of the year. Throughout the 2019, the wage growth of the informal private sector has been declining showing signs of eroding purchasing power. ASPI gained just over 1% compared to the year beginning. Due to the disruptions emanating from the Easter Attacks, services sector went through two consecutive months of contraction in April and May, while the impact on manufacturing was moderate. Tourism is the worst hit sector, but currently going through a faster recovery. Banking sector lost pace in 2019 due to eroding profitability, deteriorating asset quality and slower asset growth.
Sri Lanka’s economic growth has been in a downward trajectory for a half a decade. IMF and ADB projects the growth to be 2.7% for 2019, lowest since 2001. There are many reasons for this dismal performance, Easter Attacks being the topmost. Moreover, global growth in 2019 was sluggish amidst turbulent trade cross-currents.
Sri Lanka’s GDP recovered in 1Q following the period of political crisis in 4Q the year before. However, Easter Attacks had a devastating impact on the economy in 2Q dissipating the momentum gained in the earlier quarter. Services sector was the worst hit due to marked drop in tourist arrivals which had reverberating effect on a number of sectors in the economy. In 3Q the economy saw signs of recovery with industry and service sectors gathering impetus. However, performance of the agriculture sector continued to remain muted owing to adverse weather conditions.
The businesses and investors took a step back in December as the festive season and holidays approach. In this backdrop, we do not expect the 4Q GDP growth to be over 3%
In 4Q, with the announcement of the Presidential Elections, businesses and investors were seen adopting a “wait and see” approach which resulted in stagnation in economic activity for the most part of 4Q. Economic activities improved just after the election towards end of November on the back of positive sentiments. The businesses and investors took a step back in December as the festive season and holidays approached. In this backdrop, we do not expect the 4Q GDP growth to be over 3%.
Export sector did not experience appreciable improvement over the months in comparison to 2018. Given the global slowdown in trade, this is not entirely a bad outcome. We expect the exports to reach close to USD 1Bn in December. CBSL took several measures to combat the pressure on the external sector which resulted in contraction of imports from the 4Q of 2018. This slowdown was compounded by the low liquidity level prevailed during 1Q and continued on to 2Q and 3Q augmented by the Easter Attacks. In September exports weakened owing to drop in apparel exports but recorded an overall growth in the first 8 months. As the liquidity recovered, the imports started picking up and the figure is expected to hover below USD 2Bn mark for December. As a result of the weaker import demand and subdued oil prices prevailed for the most part of the year, we expect the overall trade deficit to be around USD 8Bn for 2019, sharply down from USD 10.3Bn in the year before.
As a result of the weaker import demand and subdued oil prices prevailed for the most part of the year, we expect the overall trade deficit to be around USD 8Bn for 2019, sharply down from USD 10.3Bn in the year before.
Major Central Banks in the world cut rates substantially in an attempt to generate growth and the CBSL followed the suit. Liquidity shortage prevailed in the latter part of the 2018 extended to the first four months of the 2019. Consequently, the T-bill yields continued to remain high through early 2019. Weaker credit demand following the Easter Attacks helped recover liquidity. With the CBSL liquidity injections and other policy measures, the Call Money rates were seen gradually declining along with T-bill yields. But as the private credit picked up from August, the Call Money rates seemed to show a gradual and consistent increase. The CBSL changed policy rates three times in 2019 to release liquidity to the market– first by cutting Statutory Reserve Ratio (SRR) by 100 basis points at the end of February, and reducing policy corridor by overall 100 basis points in two subsequent instances effectively lowering short-term rates.
The primary and secondary yields on government securities were seen falling for the most part of the year on the back of strong buying interest. Banks increased their holdings of government securities to just under LKR 1.9Tn in the period from March to June amidst faltering credit demand. Yield curve turned smoother and steeper reflecting positive growth expectations in the medium term. However, foreign buying interest remained mixed throughout the year. The yields of shorter-end government securities saw sharper decrease of over 200 basis points while medium and longer tenor instruments saw yields fall by 165-185 basis points. Successful issuance of USD 2.4Bn and USD 2Bn ISB issues in March and June, the IMF’s extension of USD 1.5Bn EFF in March, and the CBSL policy cuts in May and August sent strong signals to the market thus helping to maintain the momentum. In addition, the reverse repo auctions conducted by the CBSL to inject liquidity also helped to maintain the demand for government securities. Secondary market remained dull in August and September, moderated in October and went bullish in November. Despite these developments, government securities market recorded a net outflow of LKR 53.8Bn by the end of the year.
2019 saw declining interest rates in both international and domestic markets. Despite the CBSL’s efforts, the average lending rates did not move noticeably until May whereas AWPR continued to decline from early on. International banks seemed to offer competitive rates to their prime customers, contributing to gradual decline in AWPR. The CBSL initially imposed a cap on deposit rates in an attempt to expedite the monetary policy transmission. However, with little successes, the CBSL made significant intervention to coerce banks to cut lending rates later on. In the meanwhile, Moody’s and Fitch warned against the lending cap.
In contrast to lending rates, the interest rates applicable on Commercial Papers increased to a range of 14.85% to 16.25% from a range of 13.10% to 15.00% recorded in the first eight months of the previous year. Furthermore, interest rates applicable on Debentures also increased to 12.88% – 15.50% in the first 9 months from 12.00% – 14.75% in the corresponding period in 2018.
On the international front, major economies in the world eased monetary policies giving way for international lending rates to fall which is evident by nearly 100 basis point drop in one-year LIBOR (USD) rate.
In contrast to lending rates, the interest rates applicable on Commercial Papers and Debentures have increased during the first 9 months.
The total government expenditure for the first four months of 2019 experienced over 10% increase compared to the corresponding period the year before. In this context, credit extended to the government by banking sector expanded by about LKR 70Bn in the first four months of the year, while private sector credit contracted. Following the Easter Attacks, the private credit growth was muted but recovered in the second half of the year.
2019 began with a weaker rupee on account of the political crisis that prevailed in 4Q of 2018. As a result of foreign selling in the bond and equity markets, the rupee depreciated substantially in this period. However, the rupee appreciated in February to mid-April period as a result of improved investor confidence supported by weaker imports. Increased conversions of export proceeds and worker remittances also facilitated strengthening of rupee in the first half of the year. In months following Easter Attack and in August, the CBSL made some moderate intervention to reverse the downward pressure on rupee. Proceeds from ISBs and EFF also aided to quell some pressure off the rupee. Reserves crossed USD 9Bn mark in July. By end August, with the maturing of Swaps and Treasury bills held by the CBSL and scheduled foreign loan repayments, the money market went into a liquidity deficit once again. Conversion of ISB proceeds into domestic currency contributed to increase the liquidity level of the domestic money market in September. August Policy rate cut also drove foreigners off the bond market causing rupee to depreciate in August. Just before the November Presidential Election, bond and equity markets saw enhanced foreign buying interest which helped strengthening of the rupee in the same month. By the year end, the CBSL maintained rupee at about LKR 181/USD, marginally stronger compared to the beginning of the year. Our expectation is that reserves would settle at around USD 7.5-7.7Bn range by the end of 2019.
Our expectation is the reserves would settle at around USD 7.5-7.7Bn range by the end of 2019.
Prices & Wages
Inflation rate in the economy was moderate in 2019 and was well within the bounds of CBSL’s targets. The Food category exhibited mixed movements, while the Non-food category recorded a continuous increasing trend till November. The volatility of food prices seemed to be emanating from the adverse weather conditions. Rentals were seen escalating faster during the year. In addition, utility prices and other Fuels sub-category recorded significant increase up to November. Due to increased price of vegetables and rice the December, CCPI edged up to 4.8% from 4.4%.
Throughout the 2019, the wage growth of the informal private sector has been sliding. In addition, nominal wages of public sector employees, increased compared to 2018 due to the inclusion of special allowance and interim allowance.
In September and October months the inflation rate took over the nominal wage growth indicating eroding consumer spending power.
Unemployment rate rose to nine year high of 5.1% in 3Q of 2019 as a result of disruption caused in the economy after the Easter Attacks. Increasing unemployment level could be the main contributor for the wage growth slow down. In September and October months the inflation rate took over the nominal wage growth indicating eroding consumer spending power.
By the end of 2019 the bourse gained just over 1% compared to the beginning of the year. On a cumulative basis, the CSE recorded a net foreign outflow of close to LKR 12Bn in 2019.
ASPI deteriorated for the first five months of 2019 as investor confidence eroded following the political crisis, sluggish corporate performance and Easter Attacks. Continued equity buying by EPF helped to keep the bleeding market afloat from May and the portfolio grew close to LKR 60Bn in the September quarter. The CBSL rate cut also aided to improve the local investor sentiment in June offsetting the effect of foreign selling. But as the foreign selling continued the market rally reversed. Month of July saw ASPI soar by over 10% (M-o-M) amid high retail investor activity as investors competed to purchase undervalued stocks. This is attributable to renewed investor confidence from the launch of major infrastructure projects – Light Railway Transit (LRT) and Central Expressway by the government, CBSL policy rate cut, and favourable external sector performance. Foreign participation spiked supported by a firmer rupee, the net purchases exceeded LKR 7Bn in July. After July foreigners were net sellers who exited the market on the back of improving local investor sentiment. After the announcement of Presidential Election, the market activity improved in October and November. Chemicals Pharma, Construction Engineering, Footwear Textile, IT, Land Property, Manufacturing, and Telecom were the most resilient sectors in 2019 while Beverage Food Tobacco, Oil Palms, Power & Energy, and Stores Supplies were the most affected.
Chemicals Pharma, Construction Engineering, Footwear Textile, IT, Land Property, Manufacturing, and Telecom were the most resilient sectors in 2019 while Beverage Food Tobacco, Oil Palms, Power & Energy, and Stores Supplies were the most affected.
Easter Attacks had a major impact on the real sector. Several measures were taken to mitigate the adverse impact of Easter Attack on tourism including a debt moratorium. Due to the disruptions, services sector went through two consecutive months of contraction in April and May. Since the introduction of Purchasing Managers’ Index (PMI) in May 2015, the sector was expanding for nearly 4 years straight till the Easter Attacks. But in June the sector rebounded and started to recover. The Manufacturing sector contracted in April. This is a seasonal dip and Easter Attacks had a little impact on this contraction. But the Easter Attacks had its toll on the Manufacturing sector the following month in which the sector expanded only marginally in comparison to the corresponding period in 2018. Both manufacturing and services activities improved in October and November. Improvement in manufacturing is mainly due to an increase in production and new orders to meet the upcoming festive season demand. Employment also expanded. This was mainly due to the recruitment of new employees to increase the production levels to meet the higher demand for the period ahead. Improvement in services is mainly due to increase in new businesses in Financial and Insurance sectors. Advertising campaigns ahead of the presidential election and increased promotional activities of banks have contributed to the increase in business activities.
Notes- negative values indicate sector is generally contracting on 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
Banking sector lost pace in 2019 due to eroding profitability, deteriorating asset quality and slower asset growth. The sector faced a challenging operating environment due to multiple reasons– sluggish economy, tougher liquidity requirement, poor corporate performance, deteriorating asset quality and lending cap.
In order to decrease the real interest rates, the CBSL imposed a ceiling rate on deposits in April which lead to a notable decline in demand deposits and increase in term deposits. As a result, CASA ratio has declined increasing the cost for banking sector.
SRR cut by the CBSL released liquidity to the sector amidst liquidity shortage. As the financial sector recovered from the liquidity crunch, banks started increasing their loan assets in 1Q. Following the Easter Attacks the credit demand slumped – forcing banks to seek safe haven in government securities. Credit demand started recovering from June, and loans and advances experienced a slower but steady growth afterwards. Loan growth is mainly driven by lending by banks to the government and SOEs and not by the private sector. With the increased demand for government securities banks benefited from capital gains of their holdings.
In order to decrease the real interest rates, the CBSL imposed a ceiling rate on deposits in April which lead to a notable decline in demand deposits and increase in term deposits. As a result, CASA ratio1 has declined increasing the cost for banking sector. Meanwhile, NPL ratio reached its 5-year high in the first 8 months of 2019. The increase in NPLs was broad based, but NPLs in the agriculture sector is especially acute.
The sector was able to maintain liquidity buffers well above the prescribed levels. The CBSL revised the list of banks classified as Domestic Systematically Important Banks (D-SIB) in December. As a result, four out of the six banks have lower burden of capital requirements.
The profitability has also eroded – the ROA and ROE are at their lowest since mid-2014. With the lending cap in place the net interest margin (NIM) has decreased. Proposed tax cuts are expected to bring down the effective tax rate for banks, which could set off some of the unfavourable conditions prevailing.
Outlook for 2020
ICRA Lanka is cautiously optimistic about the economic prospects in 2020 and expect modest growth given no major external shocks take place. We made this assessment based on three factors; the possible full recovery of the tourism, expectation of relatively calmer political climate following the election early next year, and improved economic activity due to the expansionary fiscal policy and potential monetary easing. At the same time, we also emphasise the fact that in order to revive the economy, there must be political will to make tougher choices. This means the government must adopt prudent policies, maintain fiscal discipline, and implement structural reforms.
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Published date: 8-Jan-2020 Document #: aeu19
1 CASA ratio stands for current and savings account ratio. CASA ratio of a bank is the ratio of deposits in current and saving accounts to total deposits. A higher CASA ratio indicates a lower cost of funds while the lower CASA ratio indicates the opposite.