Data released by the Department of Census and Statistics shows that the Sri Lankan economy contracted 8.4% YoY in 2Q 2022, following the 1.6% YoY contraction recorded in 1Q 2022. For 1H 2022, the economy has contracted 4.8% YoY. This came in better than our expectation of a double-digit contraction for the quarter given the multiple headwinds faced. The two quarters of consecutive contraction indicates that Sri Lanka is officially in a recession. We expect this to reflect a V-shaped recovery, with 4Q 2022 looking to improve faster than expected barring any fuel and electricity disruptions. As expected, all three key sectors recorded a contraction, with the Agri and Services sectors performing better than our expectations. The Services sector which accounts for over 50.0% of GDP contracted 2.2% YoY (+0.7% YoY in 1Q 2022), while the Industrial Sector contracted 10.0% YoY (-4.7% YoY in 1Q 2022). Meanwhile, the Agri sector recorded a sharp decline owing to the fertiliser shortage, contracting 8.4% YoY (-6.8% YoY in 1Q 2022). Looking ahead, we expect 3Q 2022 to also record a contraction of 4.0% - 4.5% YoY owing to the Dollar shortages leading to extended power cuts and fuel disruptions, lower chemical fertiliser availability and low fiscal space to support consumers. However, with corrective policy measures coming into effect, and an improvement in essential supplies, we expect 4Q 2022 to perform better than initially expected. With continued inflationary pressure, we expect real household income to face significant pressure, leading to low spending capacity. We maintain our forecast of a 7.5% - 9.0% YoY contraction in 2022. While we perceive the IMF Staff level agreement a key positive, we do not factor in inflows from an EFF in 2023. Our key near-medium term concerns are 1) high interest rates and inflationary impact, 2) continued supply of essential food, medication and fuel, 3) further fiscal tightening in 2023 and 4) low reserves buffer in 2022.
Services sector records 2.2% YoY contraction despite improvements in Accommodation, F&B activities and Telco sub-sectors
The Services sector, which accounts for over 50.0% of GDP contracted at a slower pace than our expectations. This was mainly owing to a 35.3% YoY growth (-50.1% QoQ) in the Accommodation, F&B sub sector despite a significant decline in tourist arrivals during the quarter. Meanwhile, Telecommunication services also grew 8.7% YoY (+8.7% QoQ). Looking ahead, while we factor in the impact of a high interest rate environment, we expect the improvement in tourist arrivals to support the Services sector in 2H 2022. We also expect the higher economic activity evident from mid-3Q 2022 to support the Services sector going forward.
Meanwhile the financial services sub-sector contracted 19.5% YoY (+20.0% QoQ) as credit growth turned negative towards end 2Q. As such, private sector credit growth averaged 18.9% YoY in 2Q (+14.5% YoY in 1Q 2022) mainly owing to the impact from the sharp currency depreciation on loans. However, with the sharp increase in interest rates, appetite for credit has slowed down considerably.
Industrial sector contracts 10.0% YoY amidst fuel, electricity shortages, challenges to opening LCs for raw materials
The industrial sector (which contributed to 32.0% of GDP in 2Q 2022) contracted 10.0% YoY (-4.7% YoY in 1Q 2022) as most sub-categories recorded a decline in growth. A notable performance in the Manufacture of textiles and wearing apparel was recorded (+28.2% YoY, -32.8% QoQ) mainly owing to the low base in the sub-sector. Overall the impact of low Dollar liquidity, elevated commodity prices and fuel shortages were evident in the sector. The steepest contraction was recorded in the “Manufacture of coke and refined petroleum” sub-sector which was down 78.0% YoY. Construction activities which contribute most towards the Industrial sector also recorded a 16.2% YoY contraction while the “Mining and quarrying” sub-category was down 26.7% YoY.
Looking ahead, we expect 1) improved availability of fuel and electricity supply, 2) continued import controls and higher duties and 3) downward trending commodity prices to help ease pressure off the Industrial sector. However, we continue to expect elevated interest rates and lower consumer demand to dampen momentum to some extent.
Improving economic activity, fuel availability and corrective policy measures bode well for 2H 2022
Looking ahead, while we continue to factor in a steep contraction in growth for 2022, we note that the trajectory going into 4Q 2022 is better than our initial expectations given the improved availability of fuel and a relatively stable USD/LKR. However, we emphasise that fuel availability is a key factor in the equation at this point. As such, we maintain our view of a 7.5% - 9.0% YoY contraction for the year. We continue to factor in low USD liquidity and an elevated interest rate environment dampening economic productivity for the near term.
A key positive is easing global commodity prices easing pressure on the economy, given the very little fiscal space to support consumers. We see this easing further with the aid agreements finalised following the IMF Staff Level Agreement.
The higher fertiliser availability, albeit at higher prices will support employment levels in the agri sector, in our view (Agri sector which accounts for over 25.0% of labor force participation). At this point, we factor in unemployment levels of approx. 7.5% YoY in 2022 compared with the pre-Covid-19 average of 4.5%. We expect this to improve in 2023.
Amidst the current backdrop, our view remains that 1) The Agri sector will improve as fertiliser availability improves, 2) a global recession will see easing of commodity prices, which bodes well for Sri Lanka, 3) elevated inflationary pressure would limit real per capita spending, 4) currency depreciation remains a pressure point but, no sharp volatility expected in the near-term.