Sri Lanka's capital markets become stronger, more sophisticated and transparent

A post-war boom has been followed by a mixed few years for Sri Lanka’s capital markets, with a strong performance in 2014 followed by two slower years. The outlook is now brightening again as the Colombo Stock Exchange (CSE), the Securities and Exchange Commission (SEC), and the Sri Lankan government look to build the bourse’s role in the economy.

Capital markets have traditionally been modestly sized compared to the overall economy, with the CSE market capitalisation equivalent to approximately 25% of GDP, according to Nishantha Hewavithana, head of research and new products at the CSE. The bourse’s composition is also not particularly representative of the economy as a whole, with financial services companies strongly represented in index weightings, for example. Thus the bourse’s indices do not invariably track that of Sri Lanka’s macroeconomic performance as a whole.

Yet in recent years there has been a growing understanding that they can play a leading role in economic development, particularly as the country looks to boost private sector growth and foreign investment. “Long-term economic development will be contingent upon a liquid capital markets sector – and a healthy mixture of domestic and foreign investors,” Rohan Goonewardene, CEO of First Guardian Equities, a Sri Lankan brokerage firm, told OBG. “It is critical we see policy consistency from the government. If not, foreign investors may be more inclined to stay away.”

Long Tradition

The CSE dates back to the 1896 foundation of the Colombo Share Brokers Association, which in 1904 became the Colombo Brokers Association. But a formal domestic stock exchange was not established until 1985, when the Colombo Securities Exchange was founded, rebranding as the CSE in 1990. While the history of share trading in Sri Lanka is fairly long, it was modernised comparatively late, due partly to the near elimination of the market between 1956 and the late 1970s, when state socialism was the prevailing paradigm of the day, and the private sector was held back. During this period, even education in market economics was constrained as only one university taught market-related subjects. However, the introduction of liberalising reforms from 1978 reawakened the sector. Since then, the market has developed well, even weathering the 1983-2009 civil war. The largest-ever initial public offering (IPO), that of Malaysian telecoms operator Dialog, came in 2005, at the height of the conflict. The float raised the CSE’s market capitalisation by 20%, indicative both of the company’s size and importance, and of the relatively modest overall market cap at the time.

Since its initial launch, the CSE’s technical infrastructure has been repeatedly upgraded. An automated clearing and settlements system, the Central Depository System, was introduced in the early 90s, followed by the Automated Trading System in 1997 and automated surveillance in 2008.

Recent Years

The restoration of peace at the end of the civil war in 2009 corresponded with an overabundance of cheap money worldwide following the 2008 global financial crisis, leading to a surge in the market. The benchmark Colombo All Share Price Index (ASPI) rose from a 2008 low of around 1500 to a 2011 peak of nearly 7800, boosted by more than 60 IPOs following the end of the war. However impressive this looked on paper, the country was ill-prepared for the soaring equity prices and rapid increase in leverage, and in the end cracks started to appear. The SEC – the sector regulator – and the CSE moved to control what was becoming an increasingly disorganised situation, introducing credit controls and price caps, and launching investigations into suspected cases of illegitimate market activity. These efforts were not always successful, with the SEC reportedly coming under pressure, facing interference in its investigations and struggling to take a proactive stance on formulating regulatory policy. A substantial market correction exacerbated by investor concerns about regulation saw the ASPI plunge below 4800 by June 2012. As the regulator began to take a firmer grip, the global economy picked up, and confidence in the CSE outlook generally returned. The index began a stop-start recovery to early 2014, when it began a steady surge to a peak of just over 7600 in January 2015.

The CSE had an excellent year overall in 2014, with the daily average turnover rising by 71% to LKR1.4bn ($9.5m), while foreign share purchases rose to an all-time high of LKR105.8bn ($721.4m). There were five equity IPOs, raising a total of LKR2.7bn ($18.4m), the highest amount since 2011.

Investor Pullback

Since 2014 the ASPI has been affected by the general pullback from emerging markets, as well as concerns about Sri Lanka’s macroeconomic position, particularly its large fiscal deficit, growing public debt and flagging GDP growth. Political uncertainty in 2015, a double election year with both presidential and parliamentary elections leading to turnovers of power, and higher interest rates, were domestic factors affecting the decline. Overall market capitalisation on the CSE fell by 5.3% from LKR3.1trn ($21.1bn) in 2014 to LKR2.9trn ($19.8bn) in 2015. While the price-to-earnings ratio (P/E ratio) dropped from 19.6 to 17.9, following a decline in 2014, according to the SEC. Lower P/E ratios are not necessarily negative; they could suggest a rebalancing of the market and more realistic pricing, as well as making stocks better value for investors. Foreign investors participated in the pullback, with a cumulative net outflow of LKR5.3bn ($36.1m) by end-2015, following an impressive net inflow of LKR21bn ($143.2m) the previous year.

The CSE’s drop in 2015 – down 5.5% overall, according to the SEC – was actually more modest than that of many big Asian exchanges. The Stock Exchange of Thailand dipped by 14%, while the Taiwan Stock Exchange fell 10.4%, the Jakarta Stock Exchange by 12.1% and the Philippine Stock Exchange by 6.4%.

The index began 2016 at just under 6900, before dropping to 6020 in mid-March as global markets were gripped with concerns over the outlook in China – a major investor and trading partner for Sri Lanka – in particular, and the world economy in general. Doubts over the sustainability of a long-time international equity bull market, particularly with the US Federal Reserve raising interest rates in December 2015 for the first time since 2006, took hold globally. The ASPI closed the year at just under 6300, a recovery from the low of the spring, but still well down from the beginning of the year.

Turnaround

In the first months of 2017 the CSE piqued the interest of foreign investors, and the exchange looked primed to make a rebound. The ASPI has registered consistent growth since January crossing the 6500 mark in April 2017, and standing at 6640 as of mid-May. Net foreign inflow was recorded at LKR14.3bn ($97.5m) as of end-April, and overall trading activity has increased with the average daily turnover for the first four months of 2017 reaching LKR877.8m ($6.1m), up from LKR737.2m ($5m) in the same period in 2016.

Sri Lanka 20

The CSE’s leading bluechip index, the Standard & Poor’s Sri Lanka 20 (S&P SL20), has performed fairly steadily since its launch in June 2012. The index includes the 20 leading stocks on the exchange, and “aims to provide investors with an easily replicable, yet representative benchmark of the Sri Lankan equity market”, according to S&P Dow Jones Indices, which produces and manages a range of global stock exchange indices. The company developed the index in partnership with the CSE, which benefits from the increasing visibility, legitimacy, and accessibility that S&P Dow Jones and its global standards bring. The constituent stocks are classified under the Global Industry Classification Standard (GICS) developed by S&P Indices and the MSCI, another index operator, which is used by market players globally. This allows investors to more easily compare the CSE’s largest and most liquid stocks with international counterparts.

To be included in the S&P SL20, companies’ stocks must have a minimum float-adjusted market capitalisation of LKR500m ($3.4m), a six-month average daily trading volume of LKR1m ($6800) and should have been traded at least 10 days of every month for three months prior to the index’s rebalancing reference date. They must also have positive net income for 12 months prior to the rebalancing reference date, which is the annual reassessment of the index, when companies can be added or removed depending on their performance and eligibility. For example, in December 2016 Ceylinco Insurance, the country’s largest insurer, was removed from the index, as it was no longer eligible, and was replaced by textile manufacturer Teejay Lanka.

The index’s constituents are weighted by float-adjusted market capitalisation, with a maximum cap of 15% of the index for a single stock, to ensure that it remains a diversified portfolio of stocks. On the day of its formal launch, the S&P SL20 stood at 2852 and grew fairly steadily to reach 3067 by the end of 2012. It crossed the 4000 mark in September 2014, but then from September 2015 dropped again, bottoming out below 3100 in March 2015. By end-2016, it had recovered to 3496. By the end of January 2017 the financial sector made up the largest part of the S&P SL20, accounting for 43.4% of the total weighting, following GICS sector classification, according to S&P Indices. The other two dominant sectors were industrials, including capital goods, electrical equipment and machinery manufacturers, with 22.7%; followed by consumer staples, at 20.4%. Additional constituents comprised materials – including chemicals, construction materials, mining, paper, forestry products and metals, with 5.1%; telecommunication services (3.9%); consumer discretionary, including manufacturers of textiles, automobiles and components, and household durables, as well as the majority of the tourism sector (3%); and health care (1.7%).

Performance In 2016

As of end-2016 there were a total of 271 companies traded on the CSE and a total of 240 trading days. Daily trading volumes in 2016 averaged LKR737.2m ($5m), down from LKR1.06bn ($7.2m) in 2015, according to the CSE quarterly report for the final quarter. Total turnover was LKR176.9bn ($1.2bn), down from LKR235.3bn ($1.6bn) the previous year. Foreign investors accounted for 42% of turnover, an increase from 34% in 2015, an indication that activity by international players dropped off by a smaller amount than investment of local stakeholders.

The total number of trades in 2016 dropped by nearly a third, from 1.5m to 1.1m over the previous year, with 94.9% of trades made by domestic investors – indicating that foreign investors tend to make much higher-value trades than their local counterparts. “The upward trajectory of interest rates has led investors to give priority to time deposits, as is often the case in Sri Lanka,” Hewavithana told OBG. “Also, many retail investors were burned by the previous few years, and remain reluctant to return; instead they are favouring banks,” he added.

Brighter Future

Despite recent ups and downs, there is growing confidence that the outlook for the CSE is brightening with increased foreign investor interest. There are several reasons for this optimism. While the bourse’s performance has not been in lockstep with the rest of the economy, the broader context of GDP growth is an upside. The IMF forecasts growth of around 5% for 2017, while the government aims for a more optimistic 6.3%. The IMF’s three-year deal with Sri Lanka, agreed in June 2016, has bolstered investor confidence in the country by encouraging structural reform and budgetary tightening to reduce fiscal risk. There is also increasing confidence that the government elected in 2015 is committed to encouraging capital market development, including new IPOs – possibly through state-owned enterprises (SOEs) and other family-owned companies. The new leadership of both the SEC and the bourse are committed to pushing substantive changes that will strengthen the market and enhance its appeal to foreign investors in particular. “The upside potential in the equity markets is solid, with a new generation of companies preparing to list to take themselves to the next level,” Rajeeva Bandaranaike, CEO of the CSE, told OBG. Bandaranaike argues that, as in other sectors, Sri Lanka can benefit from the growth of its vast neighbour India, which has one of Asia’s largest capital markets and has become an emerging market leader in recent years. “Instead of trying to compete with India head on, Sri Lanka must find niche markets within the wider Indian-generated value streams.”

Leading Companies

The CSE is a fairly diversified exchange compared to some modestly sized emerging market bourses, but the top-10-listed companies still account for around 40% of total market capitalisation. As of February 2016 the biggest company on the CSE by market capitalisation was John Keells Holdings, at LKR204bn ($1.4bn), or 8.18% of the total, according to CSE figures. The company is Sri Lanka’s largest conglomerate, founded in the 1870s and active in seven industry sectors, including transportation, tourism, retailing, food and financial services.

Second was Ceylon Tobacco Company (CTC), another historic firm and now a subsidiary of British American Tobacco. CTC had a market cap of LKR155.5bn ($1.06bn), or 6.23% of the total. In third place was Commercial Bank of Ceylon, the largest in the private sector. The bank had market cap of LKR118.4bn ($807.3m), or 4.75% of the total. Also accounting for more than 4% of total market cap, with LKR107.5bn ($733m), or 4.31%, was Nestlé Lanka, a unit of Swiss food multinational Nestlé.

Also making the top-10 stocks were Dialog Axiata, Sri Lanka’s largest telecoms operator, with 3.59% of total market cap; Hatton National Bank, at 3.06%; followed by diversified conglomerate Melstacorp (3.04%); beverage and food company Ceylon Cold Stores (2.76%); Hemas Holdings (2.48%), a conglomerate with various interests including health care, travel and consumer goods; and Sri Lanka Telecom (2.46%), the majority of which is still owned by the government of Sri Lanka.

Regulator

After a difficult period following the 2011 stock slump, the SEC is getting back on its feet, and has bolstered its reputation as well as strengthened its oversight of the market. The SEC operates under the SEC Act of 1987, amended three times – in 1991, 2003 and 2009. Capital markets as a whole are also regulated under a takeovers code, a unit trusts code, and various other SEC rules and regulations. The regulator issues regular directives, circulars and guidelines. For some time, the market has been expecting a new SEC Act that would completely replace – rather than amend – the 1987 law. The expectation is that this would broaden the regulator’s power, including by allowing it to investigate civil as well as criminal cases of alleged breaches of law.

Civil cases require a much lower burden of proof, and thus allowing the regulator to intervene would give it a considerably greater scope to tackle market malpractices, which are seen as having been a major cause for concern during and after the post-war boom. The move is expected to boost investor confidence and would bring the SEC’s powers up to those held by most international counterparts. However, as of late 2016, there was still little concrete movement on introducing new legislation.

New Focus

In January 2015 Thilak Karunaratne, an entrepreneur and politician, was reappointed as chairman of the SEC. He had resigned in 2012, saying that he had come under pressure from some of the stock market players being investigated for stock manipulation, but returned to the post and has given the regulator new energy. The SEC soon started re-examining several cases of malpractice, launched four new ones and disbanded the existing investigations team, forming a new internal unit to conduct investigations. The SEC also streamlined and enhanced surveillance measures, and shifted to a more proactive stance on tackling potential negative impacts on the market, introducing a zero-tolerance policy on market manipulation.

Stronger Brokerages

In February 2017 the SEC issued a directive stating that stockbrokers and debt dealers operating on the CSE should have minimum shareholder funds of LKR100m ($682,800), or at least 50% of the firm’s stated capital, whichever is higher. Primary dealers regulated by the central bank, however, are exempt from the new regulation, which will be in place from January 2018. Previously, brokers were not required to maintain a minimum shareholders’ fund requirement. The move is intended to act as a catalyst for long-awaited consolidation in the brokerage sector, with those not meeting the requirement expected to boost their capital or merge with other players. The SEC has said its aim is to create stronger market players that can fully participate in the exchange, and if the regulation is fully implemented, it is expected to weed out weaker brokerages that are currently struggling to stay afloat. The measure is somewhat more stringent than expected; brokers had anticipated enforced temporary deactivation, rather than closure, if they failed to meet requirements, and therefore there may be some resistance from the brokerages affected.

New Developments

Meanwhile, the CSE is also looking to strengthen its infrastructure, as well as broaden the range of products and services that it offers investors. By the end of 2017 the CSE expects to have fully established a central counterparty (CCP) system that will enhance the settlement of securities, thereby reducing settlement and default risk for buyers and sellers. A CCP system acts as counterparty to both sides in secondary market transactions, often allowing simultaneous exchange of funds andassets. The new system – most likely to be a clearing house – is expected to facilitate a better basis for the development of derivatives trading, including short-selling, broadening the range of products available to investors, and allowing them to better manage investments and hedge risks.

Currently, the CSE is unable to offer derivatives, though plans to allow short-selling have been debated by stock exchange officials. “The CCP will definitely improve the outlook for foreign investment,” Dimantha Mathew, head of research at investment bank First Capital Holdings, told OBG. “It will accelerate procedures, improve operational efficiency and allow foreigners to invest in multiple instruments,” he added. The CSE is also working on the development of a board for listing US dollar-denominated securities. This would significantly reduce exchange rate risk for foreign investors, some of whom have been deterred by the rupee’s recent depreciation. The exchange might also attract international companies to list, with hotel operators from the Maldives reportedly interested in certain opportunities for attracting more investment through the bourse. A small and medium-sized enterprise (SME) board is also being planned for the longer term, with the new government taking a more favourable stance towards SME listings than its predecessor. As elsewhere in the world, smaller companies can find it difficult to access capital, particularly with interest rates trending upward. “We are seeing more private and public equity investment opportunities in the $2m-10m space given the current size of companies in Sri Lanka, which is pegged to the size of the overall Sri Lankan economy. We expect that there will be more investment opportunities in the $10m+ space once local businesses grow further in the next three to five years,” Sujendra Mather, managing director at York Street Partners, told OBG.

Status Upgrade

Over the longer term, the CSE also hopes to move towards the coveted emerging market status on the MSCI index; currently it is ranked as a frontier market. The MSCI downgraded the country from emerging market to standalone market status in 2001 after a ceasefire was agreed to pausing the country’s civil war, later upgrading the bourse to frontier market status in 2007, after three consecutive years of more than 30% growth in its ASPI.

An upgrade to the emerging market bracket would open access to the market for funds and other investors, which either specifically target emerging market-ranked exchanges or are barred from investing in frontier markets. However, it is likely to require the listing of at least two more large companies in order to meet MSCI requirements. These could come from major privatised or part-privatised state companies, with the government looking anew at sell-offs, including SOEs, which account for more than 80% of public debt. Among the SOEs slated for privatisation are state holdings in the tourism and travel segments, including the Hilton Hotel and the Grand Hyatt in Colombo; enterprises in the financial and utilities sectors, such as the Ceylon Electricity Board and the National Water Supply and Drainage Board; as well as the underperforming state-owned national carrier, SriLankan Airlines. Higher trading volumes, and the liberalisation of SOEs and non-core assets with strong investor appeal represent a significant development towards Sri Lanka achieving emerging market status.

Such privatisations have the potential to send strong signals to investors about the maturity, sophistication and transparency of the domestic marketplace. However, political challenges might mean that progress may take time. The CSE is also looking to develop its relatively modest corporate bond market. In 2016 the bourse’s total debt market turnover was LKR2.9bn ($19.8m), down from LKR4.71bn ($32.1m) the previous year. In the first nine months of the year there were a total of 11 corporate bond issues, with a combined value of $137m, according to the CSE’s Hewavithana. Financial services companies are the most active in debt issues, accounting for nine of the issues in January-September 2016, though manufacturing and consumer companies also float bonds.

Outlook

Sri Lanka’s capital markets had a muted two years in 2015-16 as international and domestic concerns weighed on investor sentiment. However, there is growing optimism about the outlook for the CSE in 2017, with healthy economic prospects coupled with government structural reforms and fiscal consolidation. But perhaps more important are the plans being put in place – and in some cases already being implemented – by the CSE and the SEC. The new CCP system could prove a stepchange for the bourse, particularly as far as foreign investors are concerned. Product diversification, moves to encourage IPOs and new investment platforms could help draw more investors, lifting overall liquidity and strengthening the market. Meanwhile, the regulator’s moves to crack down on the sort of poor practice that exacerbated the post-boom slump should serve to bolster investor confidence. Having said all this, many of these positive measures remain in the planning process, and implementation may prove challenging and time-consuming. Investors, stakeholders and market participants are following sector developments very closely.