Sri Lanka’s construction sector is expected to demonstrate resilience compared to other economic sectors largely due to the existence of sufficient projects, reasonably priced raw materials and funding, a report by ICRA Lanka said yesterday, but warned profitability will moderate due to lockdown and new projects will be less in the medium term.
Sri Lanka’s economic activities had slowed down during Q1 of 2020 and the economy is expected to contract by 4.5% in Q2 as per ICRA Lanka’s assessment, amidst the outbreak of the COVID-19 virus.
At the business entity levels, the ability of some construction companies to withstand the effects of COVID-19 pandemic will depend on several factors such as duration and severity of the pandemic, parent company support, the Government’s policies, and availability of additional capital buffers.
Notwithstanding the relief package introduced by the Government, ICRA Lanka expects the disruption to have some impact on the operating income, profitability, and liquidity position of the construction companies in the short term (especially during the lockdown period). However, this sector is expected to demonstrate resilience compared with other economic sectors of Sri Lanka.
Even during the lockdown period, some of the construction projects continued with special permission from the authorities. This is expected to help such projects to keep up with the original timelines and cushion the impacts from higher overheads.
In spite of the financial challenges that are likely to be faced by the Government, given the strong legal/contractual protections available for construction contractors in the event of suspensions of ongoing projects, ICRA Lanka expects the ongoing projects, especially the Government funded ones, to recommence operations soon. With the lifting of the lockdown, most foreign funded projects are expected to recommence their operations as they do not face such challenges.
In addition, most construction contracts contain force majeure clauses which can provide relief in the current situation. COVID-19, a non-political force majeure event, will make the contractors entitled to an extension of timeline in the project completion schedule to the extent of the disruption.
ICRA Lanka views this on a positive note as construction contractors with such provisions are in a better position to avoid the risk of penalties/liquidated damages on account of non-completion of the project within scheduled timelines.
“Sri Lanka’s high reliance on imports for the construction sector can pose value chain disruption risks to the sector given the stringent trade controls imposed. But the current domestic raw material production level and inventories are sufficient to sustain ongoing projects.”
Over the past several years, China and India emerged as the main import markets for raw materials for local construction industry, collectively accounting for 53% of the total imports for the construction industry in CY2018.
“After the spread of COVID-19, the Government has imposed a set of import restrictions on selected items effective for three months from 16 April. Some of the key inputs to the construction sector have also being restricted under this scheme. This step is likely to deter importers from stockpiling or building inventories to take advantage of lower global prices.”
“Given the deteriorating external position of Sri Lanka, it is expected that GoSL may be compelled to extend the import restrictions further following the expiration dates. Nevertheless, most imports for the construction industry have alternatives in Sri Lanka.”
One of the most critical input to the construction sector is cement. Main players in the cement industry in Sri Lanka involve two cement manufacturers, five bulk cement importers and 40 bag cement importers. Sri Lanka can currently produce 8.8 million tonnes of cement with plants, running at 85% capacity. Hence, in the short term, the requirements may be met with local production and existing stocks.
However, according to industry sources, higher value-added input imports have no viable alternatives in Sri Lanka. Steel structures (used for the construction of bridges), energy efficient air conditioners etc, are few examples of these product categories. The GoSL may need to lift the import restrictions for such product categories, considering the significance of this industry in the Sri Lankan economy.
“Some of the foreign funded projects are foreign currency denominated and therefore, these contracts provide a natural hedge against the increasing costs due to forex risks from the trade receivables. However, most construction projects in Sri Lanka are local currency denominated,” the report said.
Most major construction projects in Sri Lanka are funded by funding arrangements from multinational agencies and international financial institutions such as Asian Development Bank, JICA, World Bank, IDA, or bilateral arrangements with countries like China. These agencies/institutions nominate a foreign contractor as the main construction contractor of these projects. Local construction companies then tie up as subcontractors with the main construction contractors.
“Generally, subcontract assignments have relatively lower profit margins and also have lower risks. However, local subcontractors could also negotiate back-to-back subcontract agreement, where the subcontractor is also entitled for similar contractual rights including payment rights as the main foreign contractor. In these instances, timely settlement of invoices is likely and liquidity constraints will be less.”
However, most foreign funded projects generally require the Government’s initial financial commitment (up to 20-30% of the project value) to be invested before the utilisations of foreign funding lines. In the past, there have been reports of failure of foreign funded projects due to the Government’s inadequate initial funding commitments.
Projects that are subject to this arrangement at this stage of implementation may face challenges. But such projects may be limited in number at this stage, the report noted.
Sri Lanka also has initiated a number of projects where the funding may be coming from the Treasury or from local banking sources. These projects are mostly undertaken by local contractors. The projects that are funded directly by the treasury may face challenges given the current fiscal position of the Government. But the projects that have funding arranged from local banking sources may not face such challenges.
However, ICRA Lanka also would like to highlight the fact that the effect of the four reasons mentioned above can be undermined by the following deterrents.
“Given the major fiscal challenges of the Government, new tenders are likely to remain muted in the near term. The foreign funded national infrastructure order book also remains muted due to current global crisis. Therefore, these will dampen the overall industry outlook in the medium term.”
The idling of machines, manpower, and other fixed costs during the confinement would affect the profitability and liquidity position of most construction contractors to an extent. Since the fixed cost component of the construction contractor is considerable, the companies are expected to witness a moderation in profitability due to reduction in operating profit margins during the confinement period. The companies which are into high capital-intensive segments like piling would be greatly affected.
Liquidity and working capital cycle could come under pressure due to lengthening of the cash conversion cycle amidst the delay in release of funds and operational delays in the processing of bills by the clients. ICRA Lanka views that the provision of working capital support payments, such as mobilisation advances or interim payments between milestones, especially for small to mid-sized contractors during this period is key to help reduce the liquidity pressure to an extent.