Data released by the Department of Census and Statistics shows that the Sri Lankan economy was impacted by the fresh travel restrictions imposed in April, with the economy contracting 9.4% QoQ in 2Q 2021. Supported by the low base, the economy recorded a 12.3% YoY growth for the quarter. Absolute numbers show that growth has not recovered to pre-COVID levels yet, but we expect momentum to pick-up in 2H 2021 amidst a rapid vaccination drive. The Services sector which accounts for over 50.0% of GDP expanded by 7.5% YoY (-7.6% QoQ), while the Industrial Sector grew 22.1% YoY (-23.7% QoQ). Meanwhile, agriculture was the only sector to record a positive QoQ growth of 0.8% (+8.1% YoY). Looking ahead, while the vaccination drive is a positive, we expect the current Dollar shortage, lower chemical fertilizer availability and low fiscal space to impact momentum in the near term. Overall, we expect 2021 growth to improve to approx. 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, the Services sector would feel the impact stemming from a slow resumption in tourist arrivals. Our key near-medium term concern is the impact on food supply and its inflationary impact.
2Q 2021 grows 12.3% YoY on low base; contracts 9.4% QoQ due to COVID-19 impact
According to data released by the Department of Census and Statistics, Sri Lanka’s economy expanded by 12.3% YoY in 2Q 2021 (-9.4% QoQ), coming in above our forecast for the quarter. The better-than-expected result is a key positive, indicating the continued economic activity amidst restrictions to reduce the spread of COVID-19 during most of the quarter. The YoY performance was supported by the low base in 2Q 2020, where the economy contracted by 16.4% YoY; the largest drop recorded. While the recovery is a key positive, we note that 2Q 2021 GDP is below the real GDP levels compared with 2Q 2018 and 2Q 2019, indicating further room for recovery.
The impact of the restrictions was reflected in the QoQ performance, where both the Industrial (-23.7% QoQ) and Services (-7.6% QoQ) sectors recorded a contraction, while the Agriculture sector recorded a marginal growth of 0.8% QoQ.
While the travel restrictions to curb the spread of COVID-19 will negatively impact momentum, we expect a faster resumption in activity in 3Q 2021 following the successful vaccination drive in the country. This is also reflected in key leading indicators like the Purchasing Manager Index and overall Business Confidence Index which picked up, but remained below the 2021 average.
During this period, monetary policy has remained accommodative, supporting overall growth. We note that the historically low-rate environment combined with the availability of higher excess liquidity for most of 3Q 2021 will help stimulate growth to some extent as well. 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.
2H 2021 to continue momentum; low Dollar liquidity and low fiscal space key concerns to growth momentum
Looking ahead into 2H 2021, 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. 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 declined during the third wave of COVID-19, but not to the levels seen during previous cycles of restrictions. While this bodes well for all 3 sub-sectors, we expect the fastest recovery to emerge from the Industrial sector owing to higher domestic demand and the low-rate environment. While fiscal support is a key requirement to stimulate growth, the lack of space for a material impact will dampen momentum to some extent, in our view. However, recent directives to reduce State Owned Enterprise obligations by issuing hiring and new project freezes are positives. In our view, a key requirement at this point is to increase government revenue, where Revenue/GDP stood at 8.0% in 2020 (compared with over 12.0% prior to 2020).
We also expect the services sector to record a sharp pickup in activity as the demand for key sub-sectors like financial services and telecommunications continue. However, we factor in the impact of a gradual resumption in tourist arrivals in 2023. We note that a key positive is the ongoing robust vaccination drive, which will help growth momentum.
Amidst the current backdrop, our view remains that 1) The Agri sector will face pressure from the fertilizer ban amidst rising local consumer demand, 2) In Industrials and Services, we expect to see a faster pickup from 2H 2021 onwards, 3) a slow demand pickup and negative multiplier effect from low tourism will go on till 2H 2022, as most of Sri Lanka’s trading partners (the US, UK and Europe) and source markets for tourism have opened up.
On the domestic front, the key concern is the 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 expands 7.5% YoY driven by IT programming, Accommodation; contracts 7.6% QoQ
The Services sector, which accounts for over 50.0% of GDP remained in positive territory in 2Q 2021 to record 7.5% YoY growth. This came in above our forecast for the quarter. On a QoQ basis, the impact of restrictions was evident as the sector contracted 7.6% as a result of lower activity in the Transportation, Accommodation and Real Estate sub-sectors.
Looking ahead, we expect the Services sector to gather momentum along with higher economic activity in 2H 2021.
Amidst the increase in financial services, credit growth momentum increased gradually, with growth averaging 10.5% YoY in 2Q (+7.4% YoY in 1Q 2021) indicating the improving appetite for credit. This looks to have improved further in 2H 2021 amidst the low-rate environment, as the economy recovers from the third wave on the back of a continued vaccination drive. In July, we note that credit growth was at 14.3% YoY, with the Central Bank’s measures to increase disbursements towards the MSME sector.
Despite the gradual opening of tourism under a bio bubble, tourist arrivals remained weak. This was reflected in the “accommodation and F&B activities” sub-sector which recorded a 31.0% QoQ contraction in 2Q 2021 (+35.7% QoQ in 1Q 2021). Looking ahead, we expect this trend to improve albeit gradually in 2H 2021 along with the easing of travel restrictions, combined with the global rollout of the vaccine gathering momentum.
However, we expect the tourism recovery to materialise from 2H 2022 onwards.