Macro Analysis /

Sri Lanka 1Q growth picks up to 3.7% on construction and agri; financials drag

    Asia Securities
    20 June 2019
    Published byAsia Securities

    The Sri Lankan economy grew by 3.7% YoY in 1Q CY19; picking up from low growth in 4Q CY18 (+1.8% YoY), although remaining slightly below 1Q CY18 levels (4.0% YoY). The growth was largely driven by a marginal pick up in industrial activity as it recovered from a liquidity crisis in 4Q CY18. Agri improved across the board as favourable weather in 2018 led to a bumper Maha harvest. However, weak credit growth in the financial sector added significant drag on overall performance as the services sector dropped to single-digit growth. Looking ahead, we expect a slight recovery in credit growth following by the 50bp cut to interest rates. However, we believe the impact to tourism and related industries such as fresh produce, transport and retail to take a hit, following the Easter Sunday attacks. We also believe investor sentiment and business outlook to remain weak on heightened political uncertainty, clipping momentum gained within the construction sector in 1Q CY19. A number of positive factors such as the state sector wage hike, paddy income and pension upward revisions will support positive growth. However, we continue to expect 2019 to be a year of slow growth, dropping to 2.5% YoY but picking up to 3.8% YoY in CY20E.

    Growth picks up to 3.7% YoY from 4Q CY18 lows. According to data released by the Department of Census and Statistics, Sri Lanka’s 1Q CY18 GDP growth came in at +3.7% YoY (+4.0% YoY in 1Q CY18). We note that no revisions were made for previous quarters. Both the agri and industrial sectors which account for over 38.1% of GDP showed noteworthy improvement, although services recording a steep slowdown due to a credit sector decline, adding drag on overall growth (57.4% of GDP). We believe some relief from the liquidity shortage that prevailed over 4Q CY18 coupled supported growth in construction sector while a bumper harvest supported agri recovery. However, overall dampened investor sentiment and business outlook led to low credit growth in the quarter, adding drag. We note that headline inflation as measured by the CCPI index, edged up to 4.0% YoY.

    Agri buoyancy in 1Q likely to see slowing momentum from 2Q post 21/4. Favourable weather conditions in 2018 continued to bode well for the Agri sector in 1Q CY19 growing 5.5% YoY. Main growth drivers were the coconut sector (+35.6 YoY), Animal production (+9.4% YoY), and Growing of fruits (8.1% YoY). Growing of rice remained robust up 13.1% YoY coming on top of a strong base (+63.0% YoY 1Q CY18) thanks to a bumper Maha harvest. 

    However, an additional drag on growth was the maze cultivate that was negatively impacted by the Fall Army Worm outbreak, reflected by a 12.9% YoY decline in Growing of Cereal; this was the third consecutive quarter of declines. Growing of tea also experienced a marginal decline of 1.7% YoY largely due to slow productivity and slow rate of regrowth in the crop.

    Looking to the rest of 2019, delayed monsoons in the North and East pose a threat to the continuation of Sri Lanka’s agri recovery. The Eastern province contributes roughly 26.0%-29.0% of rice production (pre-drought levels 2015/2016) while the North contributes ~11.0% of the Maha season production. The bumper Maha harvest early 2019 should sustain consumption demand for the remainder of the year, adding less pressure on inflation and continuing to reduce import dependency. However, further delay of rains in 2019 could see some flat-lining in growth for 2020 Maha season. Nevertheless, the impact is likely to be far less than what was experienced in 2016/2017, in our view. However, the more significant impact comes from tourism decline post the East Sunday attacks, which has already led to a significant decline in demand for animal products as well as of fruits and vegetables, in our view. These trends are likely to clip argi income recovery from 2Q CY19 onwards, adding drag on any tailwinds from other export-oriented agri goods.

    Industrials bounces back on recovery in construction and petroleum refining. The industries sector bounced back to record 3.0% YoY in 1Q CY19, following a decline in 4Q CY18(-3.6% YoY), largely driven by a 6.9% YoY growth in the construction sector and a steep climb in the Manufacturing of coke and refined petroleum (+94.8% YoY). This was followed by a 5.8% YoY growth in mining and quarrying activity. Manufacturing of F&B and tobacco saw a loss of momentum to 2.3% YoY (+7.2% YoY in 4Q CY18, 5.6% YoY in 1Q CY18) as did manufacturing of textiles to 1.9% YoY (+3.7% YoY in 4Q CY18 and +5.0% YoY in 1Q CY18).

    Looking ahead, the dampened business outlook and investor sentiment following Easter Sunday attacks and persistent political uncertainty will, in our view, see to dampen momentum gained within the sector in 1Q CY19. While the construction sector’s liquidity crisis in 4Q CY18 is now gradually being resolved and interest rate cuts have been introduced to spur credit growth, we see very little motivation for capital formation to maintain growth momentum, and thus expect the industry to lose momentum from 2Q CY19E onwards. While the budget for 2019 indicated a pick-up housing and infrastructure development by the government under election geared programs such as Gamperaliya. However, we don’t expect it to be sufficient to trigger a strong recovery in growth. We continue to expect the apparel and textile manufacturers to experience challenging operating environment amidst trade wars and Brexit uncertainty adding pressure on global growth. This has already been witnessed in the EU markets, in line with our expectations.

    Financial services slow to single-digit growth on slowed credit growth. The services sector saw a dip in momentum to 4.1.% YoY in 1Q CY19 (+4.3% YoY in 4Q CY18, 5.5% YoY 1Q CY18) largely due to a slowdown in the financial services (9.8% YoY vs. 12.6% YoY in 4Q CY18 and 12.1% YoY 1Q CY18) owing to a slowdown in credit growth over the quarter. We note that the slowdown was significant for both the private and public sectors. Wholesale and retail activity saw a sequential bounce back (4.4% YoY) although still below 1Q CY18 levels (6.4% YoY). With tourism facing significant setbacks, following Easter Sunday attacks, we believe the services sector will be under significant pressure. However, with a 50bp rate cut introduced in May 2019, credit growth could pick up on working capital loans and public sector borrowing in the run up to elections and to fund a widening budget deficit, given slow government revenue growth.

    We maintain GDP growth forecast at 2.5% on impact from Easter Sunday attacks. From a sector perspective, it is our view that the economic impact from the Easter Sunday terrorist attacks will be felt by agriculture, consumer, retail and banking, in addition to the obvious impact on tourism. Our expectation on each sector is as follows.

    Sector-by-sector impact

    Agri: Agri is expected to increase its contribution to growth in CY19E following a bumper paddy harvest experienced beginning of 2019. Our channel checks confirm that the paddy harvesting in 1Q CY19 (‘Maha’ season) was unaffected by the attacks. However, owing to the noteworthy decline in tourism activity, we expect the demand for fresh food retail to experience a marginal impact. This, we believe, will partially offset tailwinds to growth from a bumper harvest and slowdown overall agri sector recovery.

    Industrials: We expect manufacturing to experience a temporary impact, from a) slowdown in consumption on account of the state of emergency and b) order cancellations on security and delivery concerns. However, we expect activity to normalize by 4Q CY19. With government spending set to be revised to priorities tourism and defense, along with maintaining fiscal balance, we expect to see less funds allocated to infrastructure projects.

    Services: The impact from tourism will directly impact services earnings. Furthermore, we expect the cautious business sentiment following heightened security concerns to weigh down on credit growth and increasing impairment charges which is likely to reflect on Banking sector earnings for the next two quarters (2Q and 3Q CY19E).

    Factors that could lead to an upgrade in our forecast include:
    • An increase in government expenditure following the budget revisions in June 2019
    • A significant improvement to the external balance, following a better than anticipated growth in exports