Disrupted 3Q could lead to growth shrinking to 8.2%: ICRA Lanka

• Releasing quarterly update, says projections for 4Q bleak 
• 4Q could contract 7.9%-17.8%, full-year growth 8.2%-10.9% 
• 2Q contraction could be as bad as -17.5%
• Projections much worse than -1.5% projected by CB 
• Says inflation to remain anchored at 4%

A disrupted 3Q could deepen Sri Lanka’s growth woes, rating agency ICRA Lanka warned yesterday, predicting spillover effects may see a GDP shrinkage between 7.9% to 17.8% for the 4Q, and growth for the whole year contracting by a startling 8.2% to 10.9%.  

Issuing its quarterly economic update, ICRA Lanka, which is a subsidiary of Moody’s Investor Services, projected that 2020 growth would be much worse than the 1.5% contraction projected by the Central Bank. 

The rating agency’s projections are also direr than those of both the International Monetary Fund (IMF) and the Asian Development Bank (ADB), which puts growth contraction at about 5.5%-6% for 2020.   

“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,” the report said. 

Reserve position is expected to further diminish unless supplemented with sufficient forex inflows. In addition, ICRA Lanka expects 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. 

It said 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.

“3Q 2020 was shaping up to be the turning point from the depths of economic contraction, but the fast escalation of second wave of corona infections throughout the island towards the tail end of the quarter, quickly dimmed the hopes for continued recovery.”

ICRA Lanka’s recalibrated nowcasting models show GDP growth estimates for 2Q to be -17.5% (margin of error = +/- 16%) and for 3Q to be -6.1% (margin of error = +/- 6%). Based on these predictive models ICRA Lanka expects the Sri Lankan economy to contract by 8.2% – 10.9% in 2020. 

The report said the Central Bank of Sri Lanka (CBSL) remained dovish. By allowing average overnight excess liquidity to surge by 35% to Rs. 200 billion from 2Q, the CBSL demonstrated that it would tolerate and maintain unprecedented level of liquidity in the money market to facilitate credit expansion.

July rate cut helped to ease Treasury yields but in August and September auctions, some pressure for yields to rise was witnessed. Shorter end of the treasuries, shifted down by 100 bps. Mid and longer tenor yields dropped 50 bps initially but went through an upward correction over rest of the 3Q, the report said.

Moody’s two notch downgrade of Sri Lanka’s sovereign ratings intensified the pressure for yields to rise. Bond yields, especially the mid-tenor securities, jumped 10-30 bps immediately, while trading at wider bid-ask spreads. The yields on the SLISBs edged up sharper by 170 to 540 bps.

Retail lending rates continued to slip throughout 3Q (AWPR -246 bps, AWNLR -236 bps, AWLR -143 bps). Risk appetite of the lending institutions improved and private credit showed signs of recovery in August after months of contraction.

Better-than-expected performance of exports together with import controls contributed to a noteworthy improvement in trade deficit up to August in 3Q.

Capital flight continued at somewhat moderated level. Domestic investors were upbeat post-election and the record performance of ASPI lifted it back to the pre-crisis level fuelled by the quest for higher returns in the low interest rate environment. Despite bullish local investor sentiment in CSE, the foreign investors continued to sell. Rupee displayed some volatility in August and September, but overall, appreciated slightly vis-à-vis to end of 2Q.

The Government paid down $ 991.2 million foreign currency obligations in September which brought the overall reserves down to $ 6.6 billion. This was followed by $ 1.1 billion foreign currency payments, including the maturing ISB, in October which would have further shaved off reserves.

The fiscal revenue plummeted 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%.

Tight revenue condition has 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. Though food inflation rose to double digits, low non-food inflation (<1%) resulted in the headline inflation being contained around the lower bound of the CBSL’s inflation target (i.e. 4%).