Data released by the Department of Census and Statistics shows that the Sri Lankan economy was impacted by the fresh travel restrictions combined with a high base effect, with the economy contracting 1.5% YoY in 3Q 2021. Notably, QoQ growth was 15.1% with all 3 sub-sectors recording positive QoQ growth momentum despite the heightened restrictions in August, which prevailed until early October. The Services sector which accounts for over 50.0% of GDP contracted by 1.6% YoY (+11.7% QoQ), while the Industrial Sector contracted 2.1% YoY (+20.3% QoQ). Meanwhile, agriculture was the only sector to record a positive YoY growth of 1.7% (+8.3% QoQ). Looking ahead, with the normalization of travel restrictions in 4Q, we expect a positive growth trajectory towards year end. However, we expect the current Dollar shortage, lower chemical fertilizer availability for most of 4Q 2021 and low fiscal space to impact momentum in the near term. Overall, we expect 2021 growth to improve to 4.4% YoY owing to the low-rate environment combined with the low base in 2020. While overall consumer demand has gradually picked up in-line with our expectation, heightened inflationary pressure looks to impact real household income. We expect the Services sector to benefit from the faster than anticipated pickup in tourism. Our key near-medium term concerns are 1) the impact on food supply and its inflationary impact and 2) low reserves buffer going into 2022.
3Q 2021 contracts 1.5% YoY on high base; expands 15.1% QoQ with all sub-indices recording growth
According to data released by the Department of Census and Statistics, Sri Lanka’s economy contracted by 1.5% YoY in 3Q 2021 (+15.1% QoQ), coming in marginally below our forecast for the quarter. The lower-than-expected result mainly stemmed from the high base effect combined with the travel restrictions which were in place during most of the quarter. The Department of Statistics also notes the negative impact from prolonged import controls which slowed down economic activity during the quarter.
While the impact of restrictions was not as significant on a QoQ basis compared with 2Q 2021 where the economy contracted 9.4% QoQ, we note that import controls and the lower Dollar availability dampened momentum to some extent. The recovery from restrictions was reflected in the QoQ performance, where the Industrial (+20.3% QoQ), Services (+11.7% QoQ) and Agri (+8.3% QoQ) sectors recorded positive momentum.
During this period, monetary policy was tightened by the Central Bank, with key policy rates increased by 50bps in August combined with a higher SRR requirement. However, rates remained lower than pre-COVID levels, with the availability of higher excess liquidity for most of 3Q 2021. While the excess liquidity has been absorbed, we factor in higher lending rates – albeit not at pre-COVID-19 levels – to mitigate some of the credit fueled growth momentum. As such, we maintain our view of a gradual increase in key policy rates in 2022.
4Q 2021 growth trajectory a positive; low Dollar liquidity and low fiscal space key concerns to growth momentum
Looking ahead, we expect a faster resumption in activity in 4Q 2021 following the successful vaccination drive in the country combined with the easing of restrictions. The resumption in tourist arrivals is also a key positive, and we expect this momentum to continue into 2022. This is reflected in key leading indicators, with the Purchasing Manager Index remaining above the 50 point levels since August 2021. Business Confidence also echoed this sentiment, with the Index moving marginally above the YTD average of 108 points in November.
However, we expect higher inflationary pressure coming from supply side factors and the shortage of chemical fertilizer for the Maha season to negatively impact the agri sector in the near term. While the reversal of import controls on chemical fertilizer is a positive, we anticipate price pressure owing to the removal of the fertilizer subsidy in 2022. We also expect the Dollar shortage to negatively impact imports, while lower container availability will continue to add pressure on exports.
Leading indicators like mobility data show that activity has rapidly picked up during 4Q 2021 so far. While this bodes well for all 3 sub-sectors, we expect the fastest recovery to emerge from the Services sector owing to the fast pickup in tourism combined with higher economic activity. While we expect positive momentum in the Industrial sector, we anticipate the Dollar shortage and difficulties in opening LCs to negatively impact manufacturing costs to some extent.
While fiscal support is a key requirement to stimulate growth, the lack of space to create a material impact will dampen momentum to some extent, in our view. However, recent directives issued to reduce State Owned Enterprise obligations by freezing hiring and new projects are positives. In our view, a key requirement at this point is to increase government revenue, as Revenue/GDP stood at 8.0% in 2020 (compared with over 12.0% prior to 2020).
Amidst the current backdrop, our view remains that 1) The Agri sector will face pressure from the fertilizer shortage and higher prices, 2) a faster pickup will be seen in Industrials and Services from 4Q 2021 onwards, 3) high price levels would limit real per capita income.
On the domestic front, the key concern is the low reserves and lack of fiscal space for the government to support growth momentum through a loose fiscal policy. This combined with significantly low revenue collections in 2020 and most of 2021 so far will add pressure on the multiplier effect.
Services sector contracts 1.6% YoY as Accommodation, F&B activities and Transport and Warehousing declines
The Services sector, which accounts for over 50.0% of GDP faced pressure from the travel restrictions, to record a 1.6% YoY contraction. This came in below our forecast for the quarter. On a QoQ basis, the impact from a gradual easing of restrictions was evident as the sector grew 11.7% as a result of higher activity in the Transportation, Insurance and reinsurance sub-sectors.
Amidst the increase in financial services, credit growth remained positive, with growth averaging 14.4% YoY in 3Q (+10.5% YoY in 2Q 2021) indicating the improving appetite for credit. This looks to have slowed down marginally in 4Q, as the economy recovers from the third wave on the back of a continued vaccination drive. In October, we note that credit growth was at 13.3% YoY.
Looking ahead, we expect the Services sector to gather momentum along with higher economic activity in 4Q 2021. We expect the “Accommodation, F&B” and Transportation and Financial Services sub indices to continue the QoQ momentum with the removal of travel restrictions combined with improving tourism arrivals.