Impact of recent floods on Sri Lanka’s economy

CT Smith Stockbrokers has come out with a brief and initial analysis of the impact on the economy following the recent floods. The analysis also captures impact on selected sectors. Here is the full report:

Weather patterns have changed significantly over the past few years, the extent of which has been driven home by the events of the past two months. Countries across the world, from Brazil to Australia have experienced unusual weather patterns, and Sri Lanka has been no exception.

There has been heavy rainfall over the past three months, and flooding in many areas of the country. However, the worst case of flooding occurred last week in the Eastern Province, with Batticaloa experiencing its third highest ever level of rainfall in a single day (312.3mm); the highest-ever level was in December 1967 (330.7mm).

Overall, the flooding in the Eastern Province was the worst since 1913. Meanwhile, parts of the Northern, North Central, North Western, Central, Uva and Sabaragamuwa Provinces were also affected by flooding.

The temperature in parts of the country also reached near-record lows, with the temperature in Colombo dropping to its lowest in 61 years. Since end-December 2010, Sri Lanka has experienced its highest level of rainfall in almost 100 years. This follows heavy rainfall in Colombo, which recorded its highest level of rainfall in 18 years in November 2010.

As per the Disaster Management Centre, in the Eastern Province alone, approximately one million people (260,000 families) have been affected. Around the country, an estimated 1.1 million people (287,000 families) have been affected by the floods.

The Government presently estimates the cost of the floods at Rs. 50 billion (approximately 1.2% of GDP). However, the social cost of the damage is likely to be far greater, with the people of the Eastern Province having previously been impacted by the tsunami in 2004, and the resumption of the north-east conflict in 2006-08.

Key agricultural areas have been badly affected

Agriculture and livestock have been significantly affected, as much of the land in the north and east is used by small-scale farmers for paddy production and livestock farming. While the actual extent of damage is debatable, the Government estimated that 50% of agricultural land has been affected by the floods, amounting to about 400,000 hectares.

As per officials, Sri Lanka is in danger of losing 15-20% of its food harvest, especially as this is leading up to prime cropping time during the key “Maha” season harvest, which runs from September/October - March/April. Last year, the “Maha” season harvest was over 2.6mn MT of paddy (a record harvest) out of an estimated total harvest for the year of 4-4.5mn MT. Meanwhile, the United Nations Office for the Coordination of Humanitarian Affairs (OCHA) reported that 48,679 cattle, 22,279 goats, and 172,884 poultry have been lost.

Apart from the impact on agriculture, concerns have also been raised with regard to sanitation, access to clean drinking water, and potential for outbreaks of disease in the area. Furthermore, the Security forces have warned locals returning to their homes to beware of unearthed landmines. Approximately 80% of landmines in the Eastern Province had however been removed in de-mining operations since the end of the conflict.

Impact on the Cost of Living

In a country where food accounts for approximately 45% of the inflation basket, a loss in production, and subsequent likely increase in prices, would exert significant upward pressure on inflation.

To maintain the price of rice, an essential food item in Sri Lanka, the Government stated that it would release its buffer stock of rice (188 million paddy bushels), considered sufficient for two months, into the market. Nonetheless, if the extent of the damage is severe, it is likely that the Government would require importing rice, which would likely put pressure on local prices, as global supply has been affected by inclement weather as well.

The increase in prices, however, is not only restricted to rice. Prior to the floods, prices of vegetables, onions, coconuts and eggs rose quite sharply, resulting in the Food & Beverage sub-index (of the main CCPI) rising 9.3% since July 2010. The Government recently though took measures to reduce prices, importing eggs and onions.

The high prices are however unlikely to reduce in the near future, and vegetable prices are already on the rise.

Furthermore, the Government has stated that it would not be feasible to import vegetables to control prices. If rice prices go up as well (rice has been relatively stable in 2010 due to price controls) there is likely to remain significant inflationary pressure on the economy.

Central Bank reduces policy rates in January

Contradictory to moves by other countries in the wake of rising inflation, the Central Bank of Sri Lanka (CBSL) reduced its policy rates on 11 January 2011, with the repurchase rate revised downward 25bps to 7.00%, and reverse repurchase rate down 50bps to 8.50%.

In its Central Bank Monetary Policy Review, the CBSL has noted that weather related factors and supply disruptions had resulted in the prices of certain commodities going up. However, it was of the view that “these price increases in the domestic economy are expected to have only a transient effect on domestic inflation, and current monetary developments do not indicate any significant demand pressures in the economy emanating from second round effects of these price increases” and that “in the coming months, domestic agricultural production is expected to increase along with the increase in the extent of land cultivated.”

The CBSL reiterated its stance on inflation despite the floods, stating that the impact on prices was not permanent and would not require a monetary response.

While the reduction in policy rates is a positive signal from the CBSL, with the macro environment seemingly having changed and inflationary pressure likely to be high in the economy, we believe real interest rates could temporarily turn negative in the near term.

SECTORAL IMPACT OF THE FLOODS AND INCLEMENT WEATHER

FMCG and pharmaceuticals

The FMCG and pharmaceuticals sectors would likely see an immediate increase in demand as aid agencies and donors send rations to meet the needs of those affected by the floods, and this would likely bolster sales figures in January 2011.

Organised retail

Retailers would likely benefit from an immediate surge in demand as dry rations, clothing, pharmaceuticals, food and other items are sent to displaced and affected people. If prices continue to escalate, however, retail operations may see a decline in margins and sales volume in the next few months as consumers rationalise expenditure.

Agriculture and livestock

Companies that have agriculture and livestock operations in the Eastern Province are likely to be affected by stock losses and temporarily-severed distribution channels. Meanwhile, companies that produce and market seeds, fertiliser, pesticides, etc. may see sales decline in the short term until the land is usable once more. However, these companies are likely to benefit from increased demand in the affected areas if sufficient funding is provided to farmers.

Ice cream and soft drinks

The cold weather and rain is likely to have impacted sales of ice cream and soft drink manufacturers in December and January, as sales are partly weather-dependent. Sales volumes are usually high during periods of warm weather.

Value-addition industries

It is likely that production and transport of most crops/goods from the Northern and Eastern Provinces have been, and would likely continue to be, impacted until infrastructure is sufficiently restored. Hence, any companies in the business of value addition would likely face constraints in supply (unless sufficient sources can be found), in addition to rising prices. This would likely impact margins unless the increase in produce cost can be transferred.

Banking, finance and insurance

The floods have most likely affected the repayment ability of small-time micro finance initiatives. Hence, banks that are involved in micro-finance may see an increase in their non-performing advances portfolio, and may have to provide for special losses in this regard.

The insurance sector will also be impacted by the recent floods (in both the Western province, and the Northern and Eastern Provinces), although the impact on private insurers may not be too large. The North and East of the country are unlikely to be highly penetrated, especially given the likely high cost of insurance in the area due to the high risk factors until recently.

Construction

There is likely to be significant reconstruction required in terms of housing and infrastructure. Hence, companies in the construction sector would likely benefit once reconstruction activities take place.

Tourism

Both local and foreign tourism in the month of January (especially to the North, East and Central areas of the country) are likely to be affected by the inclement weather. Foreign tourists, where possible, are likely to have postponed their vacations given that Sri Lanka is generally marketed for its sun and sand, and this may be reflected in the January tourist arrivals.

Recently, the Foreign & Commonwealth Office of the United Kingdom issued a travel notice advising its citizens about the flooding in the east of the country, and an increase in the incidence of swine flu in Sri Lanka.

Mini-hydro power

The high levels of rainfall are likely to have resulted in significant increases in the plant factor at most mini-hydro plants in the country, and therefore would likely lead to higher profits, as mini-hydros have minimal operating costs.

Plantations

While the plantation sector would likely do well in the recently-concluded December quarter due to record high rubber prices, and rising tea prices, the impact of the weather on productivity may hamper near term earnings going forward. If the continued rise in prices is insufficient to negate a likely decline in production, sector earnings would likely decline in 1Q2011E.