ICRA Lanka Midyear Economic Update: SL Current Account Balance to Reach USD 1.4 B in 2021
ICRA Lanka Limited (ICRA Lanka) on Monday releasing its Midyear Economic Update stated that they expected a smaller current account surplus in 2021 due to import compression. “The rapid pace at which the prices of global commodities rebounded has overshot our expectations for the total import bill. Therefore, we expect the current account balance to reach USD 1.4 B which is about 1.9% of GDP” it stated. Below is their forecast for the next six months.
Outlook for 2H 2021
Expedited vaccine rollouts in many major economies have enhanced global growth outlook for 2H or 2nd half of 2021. The World Bank and the International Monetary Fund - IMF revised up their forecasts from 4% and 5.5% to 5.6% and 6% respectively for 2021. Latest estimate from the World Trade Organization (WTO) sees the volume of world merchandise trade increasing by 8.0% in 2021 after having fallen 5.3% in the previous year. Many agencies and experts opine that inflation is going to be higher-than-expected, but the debate over whether it is transitory or not is still not settled. In any case, major central banks in the world have not indicated an end to their dovish outlook for the rest of the year. There is little doubt that the global recovery is going to be even with less developed countries struggling to access vaccines while combating significant stress to their external sector. The IMF has cut the growth outlook for low-income countries by 40 bps.
Trading partners’ economies
Economies of Sri Lanka’s key trading partners are expected to recover in 2021. The IMF upgraded growth projections for the US (+0.6 pps) and UK (+1.7pps) but downgraded the same for India (-3.0 pps) and China (-0.3 pps) in its July economic update.
Economic growth in 2021
Previously ICRA Lanka forecasted that the Sri Lankan economy will grow by 3.6% in 2021. In light of recently released official 1Q GDP data and ICRA Lanka’s estimates for the rest of the quarters for 2021 we downgrade our initial projection to 3.4% assuming there will be no major shocks in 3Q and 4Q.
Growth in medium-term
Sri Lanka’s growth in the mediumterm is expected to hover around 4%. Structural weaknesses, external sector vulnerability, and absence of substantial real investments makes it difficult for the country to achieve a satisfactory growth level. We expect COVID induced shocks to last through 2H while their magnitude diminishes relatively faster over the next few quarters. Thus, the economy will operate with excess capacity during this time.
ICRA Lanka believes abrupt banning of chemical fertilisers and weedicides and indiscriminate introduction of organic fertiliser could do serious damage to the output level of the agricultural sector. The adoption of organic fertiliser should be done in phases spread across an adequate time span to avoid disruption to agricultural output.
Sri Lanka’s key export destinations –US (USD 2.7 billion in exports in 2020), Europe (USD 2.8 billion) and the UK (USD 956 million) – are expected to have a stronger second half this year. Thus, monthly exports may consistently stay over and above USD 1billion for the remainder of 2021 beginning from June to bring total exports to USD 12.3 billion by the year end.
According to a global survey conducted by UNWTO, the majority of the respondents (56%) in Asia/Pacific believe it would take another three or more years for tourism to return to pre-pandemic levels in their respective countries. Before the COVID crisis, Sri Lanka’s tourism brought in about USD 300-400m in forex revenue on average per month. If Sri Lanka can meet its target for vaccination coverage, then there is a glimmer of hope that tourism may resume. But when the country will be open for tourism remains uncertain.
Sri Lanka now has a more diversified source of foreign currency remittances across many continents helping to bring sizable forex inflow to the country. Remittances are expected to have a robust 2nd half contributing about USD 6.7 billion in net forex inflows to the country in 2021.
Imports ICRA Lanka expects the total import bill to reach USD 20.3 billion in 2021. With gradual normalisation of industrial activities in China (USD 3.6 billion imports in 2020), its industrial output is expected to go up steadily. India (USD 3.1 billion) is also a critical source market for industrial inputs for Sri Lanka. However, the current COVID-19 situation in India has derailed its recovery creating supply bottlenecks. In addition, Sri Lankan manufacturers have been experiencing supplier delays since 2020 due to various logistical issues in the global supply chain, and still there is no sign of improvement.
Impact of import restrictions on the exports sector is relatively moderate as the government has accommodated some leniency for exporters in order to ensure uninterrupted production. The burden of the restrictions has directly fallen on the consumers in the form of rising prices of imported items and is expected to have a stronger contribution to inflation in 2H. To lessen the impact on the GDP, the government should consider relaxing import restrictions by imposing it on a narrower range of products.
It will be challenging to curb expansion of Sri Lanka’s trade deficit especially in the midst of faster-thanexpected rise in commodity prices in the global markets. Fuel and base metals alone contributed to 41.9% of the increase in imports in the first five months of this year. Crude oil (USD 2.5 billion fuel imports in 2020) is forecasted to grow 60-80%. Main base metals (USD 430.3 million) will see prices soaring by more than 15%. Over 20% increase in the price of sugar (USD 277.1) is forecasted for this year. Forecasted 7.4% fall in tea (USD 1.2 billion in exports) price will be a blow to tea exporters, but the overall adverse impact on country’s export revenue may be to some extent offset by the 30% increase in rubber (USD 810.2 million in rubber and rubber products exports) prices. Nonetheless, Sri Lanka’s terms-oftrade will continue to deteriorate despite having import restrictions. We expect the trade deficit to widen to USD eight billion by the end of 2021.
Inflows to the capital (financial) account will continue to be weak in 2H. As of the end 1H, total foreign ownership in equities and treasuries was LKR 29 billion which roughly translates to about USD 132 million. In this context, net outflows (i.e., primary income) from treasuries and equities would also remain low and we expect the total net outflow to be around USD 200 million in 2021. In light of improved global economic outlook, we revise up expected FDIs in 2021 to USD 500 million.
Initially, ICRA Lanka expected a smaller current account surplus in 2021 due to import compression. Rapid pace at which the prices of global commodities rebounded has overshot our expectations for the total import bill. Therefore, we expect the current account balance to reach USD 1.4 billion which is about 1.9% of the GDP.
Going forward, fluctuation in the trade deficit is likely to be the principal determinant of the exchange rate assuming all export proceeds are converted to rupees. Currently, the rupee is pegged to USD at 200 and has caused severe shortage of foreign currency in the spot market among the banks. The Sri Lankan rupee has a strong tendency for volatility clustering. We believe the current peg is unsustainable unless there is a material improvement in forex inflows. Therefore, further depreciation of the currency is likely.
At the end of 2020 total foreign currency obligations stood at USD 6.8 billion. This includes settlement of USD 1billion ISB maturing in July. We expect the Government to rollover about USD1.5 billion existing obligations, and borrow about USD 4.5 billion via bilateral/multilateral arrangements. As per ICRA Lanka’s projections, in this setting total gross official reserves would fall to USD 3.8 billion by the end of 2021.
Fiscal deficit and government debt ICRA Lanka revises its forecasts to reflect the impact of the third wave of infections on the fiscal variables. Accordingly, we expect the revenues to weaken to 9.1% of the GDP in 2021 from 9.2% in 2020 amid the current subdued domestic economic situation. However, the Government may observe gradual normalisation of revenues in 4Q 2021. The expenditure will grow relatively slowly and will sit around 19.8% of the GDP. The overall expenditure in absolute terms may expand at the expense of capital expenditure. In this context we expect the fiscal deficit to improve to 10.7% of the GDP but the debt stock will further increase to 104.8% of GDP.
Gradual recovery of the economy and rising inflation expectations is driving the treasury yields higher which ICRA Lanka believes will resist downward adjustment of retail lending rates in the medium-term. We feel, T-bills may potentially move up by another 10-20 bps in 2H. Therefore, we expect the AWPR to fluctuate in a relatively broader range between 5.50-to-6.50% for the rest of the year. Due to external sector vulnerability, potential acceleration in credit, and expected rise in inflation, we do not believe the CBSL has scope for a further easing of the policy rates in 2H. On the other hand, the CBSL has emphasised its commitment to keep interest rates at single digits. Hence, it is very likely that the CBSL will maintain its current policy window through 2H. In this context, we may see moderate levels of liquidity in the money market effectively driving overnight rates higher. Therefore, the average call rate for 2H may range between 4.60 to 5.10%.
ICRA Lanka views 2H to have a relatively higher inflation level than 1H for a number of reasons – (1) vaccination rollout is expected to add a boost to consumer spending; (2)rising commodity prices; (3)scarcity of goods rendered by the import restrictions and speculative element that comes with it; (4) weaker rupee which makes imported goods even more expensive; and (5) vagaries of weather which results in supply shocks to agricultural produce. Thus, we revise our CCPI (Y/Y) average inflation forecast to be between 5-to6% for 2H.
Economy at a glance for 1H 2021: Economy relapses amid the third wave
First quarter recorded a modest economic growth (4.2%) but the rapid escalation of the third wave of COVID-19 infections stalled the momentum telling us that the pandemic will continue to cast a longer shadow over the economy. Our now casting models indicate that Sri Lanka’s GDP may have grown at around 4.1% in 2Q.
Improving economic activities post relaxation of the lockdown brought the wages on an upward track on the back of growth in services and industries wages. Headline Inflation started to climb up in 1H as a result of uptick in non-food inflation. Following the fuel price hike in June, inflation made the biggest jump since the beginning of the pandemic last year. Supply shocks caused food inflation to remain high at double digits before moderating to upper single digit levels in 2Q. The CBSL maintained a dovish stance in monetary policy throughout 1H.
The money market rates remained broadly steady and subdued in 1Q. Treasury yields edged up. Retail lending rates further declined. Improved mobility after the relaxation of lockdown measures together with the April new year festive season elevated consumer spending and retail trade activities boosting willingness to lend among lending institutions to drive private credit. However, the gloomy outlook that followed immediately in the wake of the rising third wave of infections eroded the optimism.
In April the rupee abruptly appreciated for a short duration only to spring back and remained around 200 for the rest of the quarter in what appears to be an attempt to use moral suasion to prevent the rupee from depreciating. Consequently, the liquidity in the interbank forex market dwindled paving the way for the black market to thrive. Monthly merchandise exports during the first five months of 2021 outperformed its corresponding year-ago levels by 33.3%. Imports went up by 26% mainly due to increasing commodity prices. With the deterioration in terms-of- trade, Sri Lanka was unable to achieve a material improvement in the trade deficit.
Remittances managed to perform consistently well above the last year levels (+18.2% in 5M 2021). However, tourism receipts (-97%) remained at dismal levels under current international travel restrictions. Throughout 1H Sri Lanka struggled to preserve or improve its reserve position while the country’s import cover was on a downward trajectory (5.7 months in January to 4.6 in May). Following sovereign rating downgrades by multiple agencies towards the end of 2020, the yields on SLISBs were on the rise mostly during 1H apart from few occasions where markets responded to positive news.
Government revenue stagnated in 4M 2021 growing only by 0.8% despite modest recovery in GDP in 1Q. As a result of elevated expenditure level together with stagnant revenue, the fiscal deficit has further expanded (+15.1%). The deficit was primarily financed through domestic borrowings in the form of treasury bonds and bills. This has brought the total stock of debt over LKR 16 Trillion by the end of April 2021.