Economic Analysis - Growth Downgraded But Construction Outlook Still Positive - AUG 2017


BMI View: We now expect Sri Lanka's real GDP growth to come in at 4.3% in 2017 (from 5.0% previously ) , before recovering to 4.9% in 2018, as adverse weather conditions are likely to have a lasting negative impact on the economy. We remain positive on both the construction and export manufacturing industries, but note that risks are weighted to the downside with regards to the latter.

Sri Lanka posted a real GDP growth estimate of 3.8% y-o-y in Q117, marking a considerable slowdown from the provisional figure of 5.3% y-o-y reported in Q416 and the full-year clip of 4.4% in 2016. The disappointing growth performance in Q116 was largely due to the severe drought in the country from November 2016 to April 2017, which weighed on overall agricultural output. Meanwhile, the service industry also saw weak growth of 3.5% y-o-y in Q116 caused by negative spillover effects from the adverse weather conditions, as well as the government's fiscal consolidation efforts. Although we remain positive on the construction and export manufacturing sectors, adverse weather conditions will likely to have a lasting negative impact on the economy. Accordingly, we now forecast Sri Lanka's real GDP growth to come in at 4.3% in 2017, down from 5.0% previously, before recovering to 4.9% in 2018.

Agriculture Sector A Drag On Headline Growth
Sri Lanka - Real GDP Growth By Sector, % chg y-o-y
BMI, R= Revised, P= Provisional

Adverse Weather Conditions To Have Lasting Negative Impact On Agricultural Output

Looking at GDP by production, the agricultural sector contracted by 3.2% y-o-y in real terms in Q117, following a contraction of 8.4% y-o-y in the previous quarter. This underscores the severity of the drought that crippled the country's agricultural sector and saw rice production collapsed by 53.1% y-o-y in the first quarter of the year. According to the World Food Programme and officials from the country, the drought was considered the worst in 40 years and created a humanitarian and economic crisis which affected more than 1.2 million people. To make the situation worse, the country was embattled by Cyclone Mora in late-May, which brought about the worst flooding and landslides in the country in 14 years. According to the official Disaster Management Centre, the death toll has topped 200, while more than 600 thousand people were displaced from their homes. Given the extensive damage to crops caused by heavy flooding in 15 out of the island-nation's 25 districts, we expect agricultural production to continue contracting (on a y-o-y basis), and act as a drag on headline growth over the remaining course of the year.

Service Industries Also Taking A Hit

With millions reeling from the adverse effects of the drought and floods, we believe that this will continue to take a toll on the services sector over the coming quarters. Already, the drought has contributed to the poor performance of the services sector in Q116, with education, real estate, IT, professional services sectors all either growing below 1.0% or contracting as households struggled with food insecurity. It is likely that the flood situation which swept away crops and infrastructure (such as houses, schools, bridges, roads, etc) has exacerbated the situation.

Furthermore, we believe that the effects of the VAT hike from 11% to 15% (implemented in September 2016), the imposition of higher income taxes, and government efforts to pare back its fiscal deficit will continue to act as a damper on growth in the service industry over the remainder course of the year. For the first time since 2013, 'public administration and defense; compulsory social security' contracted by 4.9% y-o-y in Q117, and this could signal renewed efforts by the administration to finally curb excessive spending.

Construction To Outperform

Despite weakness in the agriculture and services sectors, the industrial sector managed to expand by 6.3% y-o-y in Q117, lifted by the construction sub-segment which grew by 16.1% y-o-y in real terms. This reinforces our view for the construction industry to outperform as the government continues to push for large-scale roads, rails, and port developments such as the Colombo Port City development project and the Western Region Megapolis Planning Project. According to our infrastructure team, Sri Lanka's construction industry will continue to be one of the fastest-growing globally as a slew of high-value transport projects in the pipeline drive infrastructure activity and facilitate the development of residential and non-residential buildings across the country ( see ' Transport Sector Underpinning Construction Industry Growth ' , May 31 2017). Additionally, rebuilding efforts following the disaster will likely contribute positively to construction growth.

Export Manufacturing Sector Growth To Pick-Up...

Meanwhile, we believe that the reinstatement of the Generalised System of Preferences (GSP) plus status for Sri Lankan exports to the EU in May 2017 is likely to provide much-needed temporary relief to the country's export manufacturing sector. By obtaining this concession, Sri Lanka will now benefit from the full removal of tariffs on its exports to the EU on 66% of tariff lines (approximately 1,200 Sri Lankan products), covering a wide array of products including textiles, small machinery, and seafood. Given that the EU is Sri Lanka's largest export market, this will likely benefit Sri Lanka's export manufacturing sectors - particularly garment exports, which make up nearly half of total exports. Since the GSP Plus concession was revoked in 2010, Sri Lanka's ready-made garment export sector has struggled to compete with its counterparts like Bangladesh, Pakistan, and Vietnam, where wages are considerably lower and the labour force significantly larger.

Sri Lanka Has A Middling Position
Asia - Ease Of Doing Business Ranking, Out Of 190
BMI, World Bank. 1= Best, 190= Worst

...But Downside Risks Remain

That said, we note that Sri Lanka's ready-made garment manufacturing is facing structural and external limitations which could undermine the country's ability to fully leverage the benefits of the GSP-Plus. Firstly, the apparel sector is currently facing labour constraints that could undermine the ability of the sector to expand sufficiently to meet increased demand from the EU. Secondly, as its regional competitors such as Vietnam continue to embark on economic reforms to improve their business environment, Sri Lanka's political instability could widen the gap in terms of competitiveness. As it stands currently, Sri Lanka ranks significantly ahead of Bangladesh and Pakistan in World Bank's 2017 Ease of Doing Business survey, but already lags behind Vietnam (see chart). Thirdly, Brexit is likely to diminish the benefits of the GSP-Plus concession, given that the UK accounts for 30% of Sri Lankan exports to the EU - Sri Lankan exports will no longer qualify for preferential access to the UK once it leaves the EU.

Macroeconomic Forecasts (Sri Lanka 2013-2019)
Indicator 2013e 2014e 2015e 2016e 2017f 2018f 2019f
National Sources/BMI
Population, mn 20.5 20.6 20.7 20.8 20.9 21.0 21.1
Nominal GDP, USDbn 74.3 79.3 80.5 80.3 79.5 84.9 93.0
GDP per capita, USD 3,619 3,847 3,887 3,856 3,801 4,044 4,410
Real GDP growth, % y-o-y 3.4 5.0 4.8 4.4 4.3 4.9 5.1
Industrial production, % y-o-y, ave 0.7 2.3 3.8 4.4 4.5 4.7 5.2
Consumer price inflation, % y-o-y, ave 6.9 3.3 0.9 3.6 5.1 5.3 5.0
Consumer price inflation, % y-o-y, eop 4.7 2.1 2.8 4.5 5.6 5.0 5.0
Central bank policy rate, % eop 8.50 8.00 7.50 8.50 8.50 8.50 8.50
Exchange rate LKR/USD, ave 129.13 130.59 136.01 147.50 154.00 158.56 159.75
Exchange rate LKR/USD, eop 130.79 131.20 144.25 150.23 157.77 159.35 160.15
Budget balance, LKRbn -516.1 -591.2 -829.5 -687.6 -642.8 -587.6 -517.1
Budget balance, % of GDP -5.4 -5.7 -7.6 -5.8 -5.3 -4.4 -3.5
Goods and services exports, USDbn 13.9 14.9 14.6 14.6 15.2 15.8 16.5
Goods and services imports, USDbn 22.7 25.0 25.3 26.5 27.6 29.1 30.7
Current account balance, USDbn -2.5 -2.0 -1.9 -1.9 -1.3 -0.6 0.1
Current account balance, % of GDP -3.4 -2.5 -2.3 -2.4 -1.6 -0.7 0.2
Foreign reserves ex gold, USDbn 7.5 8.2 7.3 8.0 9.0 10.2 11.6
Import cover, months 5.0 5.1 4.6 5.0 5.4 5.9 6.4
Total external debt stock, USDbn 39.2 42.3 43.9 45.9 47.7 49.1 50.3
Total external debt stock, % of GDP 52.8 53.3 54.5 57.2 60.1 57.9 54.1