A force of external and internal factors lead to mixed outlook for Sri Lankan capital markets

After a positive second half in 2017 Sri Lanka’s capital markets experienced considerable headwinds in 2018, with a variety of external and internal factors behind the buffeting. The impacts of macroeconomic issues, increasing competition in terms of investment options, political uncertainty, turbulence in global energy prices and moves by the US Federal Reserve could be seen in both equity and bond markets. As 2019 got under way foreign outflows continued, while bond spreads widened – both signs of challenges ahead.

This left many key companies undervalued and demand for long-term bonds high as investors looked for more secure havens in the country’s debt market. Many see prospects for a turnaround as the year progresses, particularly if moves to expand and deepen the market begin to take hold and the overall economy grows within the government’s structural reform agenda. However, political risk remains a factor as the upcoming election in 2020 could be pushed forward to some time in 2019, a move that might encourage many investors to adopt a wait-and-see attitude.

Sturcture & Oversight

The main oversight body for the capital markets is the Securities and Exchange Commission (SEC). Initially set up in 1987, under the SEC Sri Lanka Act, the body was subsequently amended in 1991, 2003 and 2009, and has been headed by the director-general, Vajira Wijegunawardane, since 2015. Plans to update and consolidate the original 1987 legislation have been under way, and this is likely to see continued discussion during 2019.

The commission currently consists of 10 non-executive members, who constitute its policy-making body, with six of these appointed by the minister of finance. Among other powers, the SEC is responsible for granting licences to companies, stock brokers and dealers to operate on the exchange, and for companies to manage unit trusts. It also certifies market intermediaries and monitors market participants to ensure that they work in accordance with SEC codes. The body advises the government on the sector’s development, and in this regard has issued a number of master plans over the years. The most recent of these is the Capital Market Strategy 2020, published in March 2017 and developed after a review of the country was undertaken by the International Organisation of Securities Commissions (IOSC). The plan aims to combine regulatory and governance reforms with development strategies.

The Exchange

Most of the SEC’s focus is on the Colombo Stock Exchange (CSE), located in the World Trade Centre in Colombo since 1995, with branches in Kandy, Jaffna, Negombo, Matara, Kiribathgoda and Gampaha. The exchange was initially incorporated in 1985 and took on its current name in 1990. In 1991 the CSE launched the Central Depository System (CDS) – a subsidiary which is licensed as a market intermediary and clearing house acting as a depository for traded securities – and in 1997 it introduced the Automated Trading System as its main trading infrastructure.

In June 2018 the Central Bank of Sri Lanka (CBSL) – which also owns a clearing and settlement system for government securities – announced that it was tendering for consultancy services in the implementation of a new, straight-through processing initiative. This would enable the establishment of an electronic trading platform, a central counterparty clearing and settlement system, and a central securities depository. This forms a key part of the Capital Market Strategy 2020.

The CSE operates as a mutual association controlled by 15 full member brokerages; however, there has been some criticism of this structure by market entities, with the 2020 strategy also calling for demutualisation. In early 2018 a bill providing for the CSE to become a limited firm reached the Parliament, and regulators stated that the names of the directors and initial shareholders needed to be provided within nine months, although no update had been announced as of early 2019.

The bourse is a member of the World Federation of Exchanges, the South Asian Federation of Exchanges and the Sustainable Stock Exchanges initiative, while the CDS is a member of the Asia-Pacific Central Securities Group. In 2015 the CSE also signed a memorandum of understanding with the Maldivian Stock Exchange, aimed at cooperation and mutual development.

Boards

The exchange has two boards, the Main Board and the secondary Diri Savi Board. Companies wishing to list on the latter must have stated capital of at least LKR100m ($630,000) at the time of listing, while those listing on the former must have at least LKR500m ($3.1m). For both boards, a company must have been active for at least a year before listing.

In January 2017, as part of efforts to deepen involvement in the market, the SEC introduced new rules regarding the minimum public holding of shares in listed companies. Companies listed on the main board maintaining more than LKR10bn ($63m) in free float market capitalisation have no minimum public float requirement, while those maintaining LKR7.5bn ($47.2m) required to have a public float of 5%. Firms maintaining LKR2.5bn ($15.7m) need to have 10%, and those below these limits face a minimum requirement of 20%. On the Diri Savi Board, these levels were set at a free float market cap of LKR1bn ($6.3m) requiring a 7.5% public float and 10% for everything below this level. The minimum number of shareholders for the two boards was stipulated as 500 and 200, respectively.

After initial opposition from some firms and brokers, a grace period for compliance was granted that extended the deadline to June 2017. Speaking to OBG in December 2018, CSE officials stated that most companies now meet these requirements. However, in the first half of 2018 there were also a number of transfers by companies from the Main Board to the Diri Savi Board, to take advantage of the lower requirements.

In July 2018 the CSE and the SEC launched Empower, a further board, which is dedicated to small and medium-sized enterprise (SME) listings. Designed to expand the reach of the capital markets, companies with stated capital of between LKR25m ($157,000) and LKR100m ($630,000) are entitled to list on this board, provided they have also been in operation for a minimum of five years. An awareness campaign is now under way to attract SMEs to list, with this set to continue in 2019.

In December 2018 the CSE also announced that it would launch a dollar-denominated board for foreign firms to trade on the exchange. This will initially be open to overseas-based firms looking for a secondary listing in Sri Lanka, with the stipulation that such entities would have to be already listed in their home countries on an exchange recognised by the IOSC. The plan is for this board to widen in the future to incorporate multiple currencies, while in the short term appealing to companies listed on relatively small exchanges.

Tracking & Monitoring

There are two market indices for companies on the CSE: the All Share Price Index (ASPI) and the Standard & Poor’s Sri Lanka 20 (S&P SL20). The ASPI includes all listed companies, weighted according to market cap, while the S&P SL20 lists the top-20 companies, selected according to S&P’s global index methodology. Another key institution in the sector is the Sri Lanka Accounting and Auditing Standards Monitoring Board, which is an independent authority mandated to review companies’ financial statements. There is also the Insurance Regulatory Commission of Sri Lanka, which oversees insurers and comes under the Ministry of Finance. The unit trust segment, meanwhile, has its own professional organisation, the Unit Trust Association of Sri Lanka, with 14 registered members as of January 2019.

Size & Performance

The sector comprises government securities, stocks and corporate bonds, with no derivatives or commodities markets currently operational. There is a small unit trust industry, while pension funds are dominated by two mandatory, state-managed superannuation funds: the Employees’ Provident Fund (EPF) and the Employees’ Trust Fund (ETF).

The CSE trades both equities and government and corporate debt securities. In terms of equities, as of January 2019 the CSE had 297 companies listed from 20 different sectors, along with 28 brokers, and a total market cap of LKR2.8trn ($17.6bn). As a percentage of GDP, this figure is comparatively low in relation to market peers: in 2017 market cap of listed domestic firms as a percentage of GDP in South Africa, Malaysia and India represented 352.8%, 144.8% and 89.6%, respectively, compared to 21.7% for Sri Lanka, a figure that had fallen steadily from a 2014 peak of 29.8%, according to World Bank data.

The sector with the largest number of listed firms was food, beverages and tobacco (FBT), with 55 as of early 2019. This was followed by diversified financials (53) and consumer services (39). In terms of market cap, the largest sector was also FBT, with LKR773.4bn ($4.9bn), followed by capital goods with LKR423.1bn ($2.7bn), and banks with a value of about LKR398.7bn ($2.5bn).

Turnover

CSE data for the fourth quarter of 2018 shows that total number of stocks traded reached a turnover of LKR59.1bn ($372.2m), up from LKR55bn ($346.3m) one year earlier and LKR31.6bn ($199bn) in the third quarter; however, full-year data put turnover at LKR200.1bn ($1.3bn), down from LKR220.6bn ($1.4bn) in 2017. Meanwhile, the bourse’s debt market saw turnover reach around LKR1.45bn ($9.1m) in the fourth quarter of 2018, up from LKR655.9m ($4.1m) y-o-y and LKR571.4m ($3.6m) in the third quarter. For the entire year, this figure grew to LKR4.5bn ($28.3m) from LKR3.6bn ($22.7m) in 2017.

Foreign Influence

CSE data show the importance of foreign activity to the exchange, as foreign institutional investors (FIIs) own large shares of the public holdings of major traded companies. According to analysis based on the third quarter of 2018, Lion Brewery, which was the 12th largest by market cap at the time, had a public float of 20.3%, with around 86% of this owned by FIIs. Meanwhile, Ceylinco Insurance was the 15th largest by market cap, with 43% of its 75.3% public holdings held by FIIs; and the number-one listed company by market capitalisation, Ceylon Tobacco, had a public holding of 15.8% – which is less than the new statutory requirement – with approximately 84% of these shares in hands of foreign players.

Foreigners accounted for a substantial 42% of equity turnover in the last quarter of 2018 and 44% for the year; however, these numbers are a contraction from 2017, when FIIs accounted for 48.9% of fourth quarter turnover and 46.8% for the year, demonstrating the declining role of outside entities in the market in 2018. This was due to global headwinds – caused by rising US interest rates and bearish sentiment towards emerging market assets in general – and exacerbated by domestic socio-political issues.

Outflows & Currency

Indeed, net outflows from FIIs began earlier in 2018, after two years of positive performance. According to figures from JB Securities, a leading broker and founding member of the CSE, while 2016 and 2017 saw net inflows of $12.6m and $121.2m, respectively, the first three quarters of 2018 posted a net outflow of $35.7m. This continued into early 2019, as political uncertainty took hold, with FIIs selling some LKR13.9bn ($87.5m) in stocks between October 26 and January 9. This was in stark contrast to the opening weeks of 2018, which had seen record-breaking FII inflows of around LKR4bn ($25.2m) in January alone.

It seems likely that “hot money” – funds that are being rapidly transferred from the country to benefit from favourable exchange rates and conditions – accounts for some of this. In common with many other markets, Sri Lanka experienced the downside of four US Federal Reserve rate hikes during the year, the last being in December 2018. As US monetary policy tightened, the dollar strengthened, with the Sri Lankan rupee weakening and hot money outflows increasing. Given the country’s high external debt stock and level of imports, the economy is particularly susceptible to such international movements. The currency continued to weaken during the political uncertainty around the end of 2018, closing at LKR182.9:$1, having falling from LKR153.9:$1 at the beginning of the year.

In addition, 2018 saw subdued activity from local equity investors. There are several big contractual savings institutions that traditionally lead the market: ETF, EPF and the Sri Lankan Insurance Company. However, the first two of these – which had respective capital markets portfolios of LKR261bn ($1.6bn) and LKR2trn ($12.6bn) in 2017 – were both rendered inactive by ongoing investigations into conflicts of interest and insider trading related to a 2015 CBSL bond scandal.

The number of active domestic investors has also been declining. Figures from JB Securities suggest that in 2014 some 1.13% of the total economically active population was active on the equity market, making at least one CSE transaction during the year; however, by 2017 this figure had declined to 0.39%. One major reason for this has been continuing high fixed deposit rates available elsewhere. “With banks able to offer 11-12% interest on deposits, the incentive to undertake activity on the CSE is certainly weak,” Murtaza Jafferjee, chairman and CEO of JB Securities, told OBG.

In January 2019 the CBSL standing deposit facility rate and lending rate were 8% and 9%, respectively, while the bank rate stood at 15%. Meanwhile, earnings growth on the CSE slowed from 20.2% in 2017 to 9.64% in the first nine months of 2018. This impacted the CSE’s price-to-earnings ratio, which, while steadily rising during the first quarter of 2018, peaked in April at around 11.5 and then began a steady decline, falling to around 8.5 in early 2019. Overall, the ASPI closed 4.9% down on the year, while the S&P SL20 closed down 14.6%. This placed Sri Lanka within a regional pattern, with the markets in Hong Kong, Malaysia, Thailand and Taiwan also closing on a negative note.

Listings

Buoyed by the good results of 2017, however, the CSE saw its first new listing in January 2018, when property and tourism firm Jetwing Symphony rang the opening bell to commence trading, coming after an initial public offering (IPO) that raised LKR753m ($4.7m). In early 2019 the CSE reported that a total of LKR99.3bn ($625.4m) was raised through IPOs, rights issues, and public and private placements during the previous year, up from LKR73.5bn ($462.9m) in 2017 and LKR85.6bn ($539.1m) in 2016.

Debt Market

The first half of 2018 also saw many banks issue debt securities and debentures as they moved to meet the new Basel III requirements (see Banking chapter). Debt also benefitted from changes in the equity market, as rates became more attractive and fixed income provided a less risky haven for investors.

Corporate and government debt securities are traded via secondary facilities on the CSE, with two separate settlement boards available: the TOM Board for early settlement and the SPOT Board for late settlement.

Long-term government bonds were popular during 2018, as insurance companies in particular looked for ways to ensure stable returns over the years ahead. In April a record $2.5bn in sovereign bonds was sold, with 10-year bonds priced at 6.75% and five-year bonds at 5.75%. As the year went on, however, worries about political risk, large-scale forthcoming government debt repayments, the upcoming end of the IMF programme, inflation and currency depreciation discouraged investors. By November, when the political crisis was still ongoing, the yield on 10-year Treasury bills (T-bills) and bonds was 12.23%, while five-year and three-month paper yielded 11.8% and 9.93%, respectively. Following the crisis’ resolution, the yield curve did shift slightly downwards, however, ending the year at 11.95% for 10-year T-bills and bonds, 11.7% for five-year instruments and 9.8% for three-month notes.

Unit Trusts

Unit trusts made some progress in 2018 after a turbulent year in 2017. That was because of uncertainty over new tax provisions, due to begin in April of that year, which took away a withholding tax exemption on the dividends received by corporate unit holders, while boosting income tax liability from 10% to 14%. This caused a major outflow at the time – around 80% of the funds in the industry are corporate – though the industry subsequently recovered ground.

As of November 2018 the sector’s five-biggest unit trust funds in terms of assets under management were the NDB Wealth Money Plus Fund (LKR14.2bn, $89.4m), the CAL Investment Grade Fund (LKR8.2bn, $51.6m), the JB Vantage Money Market Fund (LKR4.45bn, $28m), Guardian Acuity Money Market Fund (LKR4.35bn, $27.4m), the CAL Income Fund (LKR3.7bn, $23.2m) and Assetline Income Fund (LKR2.8bn, $17.5m).

Outlook

The year ahead is likely to be characterised by continuing political uncertainty in Sri Lanka, with the prospect of the 2020 elections being brought forward and the fall-out from the October 2018 crisis continuing to impact the government. The market will also have to adapt to external risks, such as potential further US Federal Reserve rate hikes, a slowdown in the global economy and fluctuations in oil prices.

Under such circumstances, it may be that 2019 will be a year for many investors to show caution; however, it may also present an opportunity. Many CSE-listed companies are likely undervalued, while longer-term bonds offer attractive rates. Much will depend on how the government manages the political and economic obstacles it faces in the near term, while the capital market itself continues along the path of the 2020 strategy, seeking a wider and deeper pool of investors.