Foundations are set for future growth of Sri Lanka's capital markets

The Sri Lankan capital markets are recovering after a period of great change and a measure of controversy. Stocks boomed when the civil war ended, only to fall back as regulation and regulators were unable to keep up with the surge in activity, and manipulation and unfair dealing were alleged. With a new government in power, the apparent wrongs of the past are being addressed and a roadmap for the future is being drawn. Laws are being written, rules are being updated and key market infrastructure is being developed. The exchange and the regulator are being overhauled and upgraded. These efforts are seen as vital to the future of the country, as efficient, effective and fair capital markets are needed to attract and deploy the capital Sri Lanka needs.

Deep History

The Colombo Share Brokers Association was founded in 1896 and in 1904 this became the Colombo Brokers Association (CBA). A formal stock exchange, the Colombo Securities Exchange, was founded in 1985, with it rebranding as the Colombo Stock Exchange (CSE) in 1990. Share trading all but vanished from 1956 through to the late 1970s due to the rise of socialism in the country. Only one university taught market-related subjects during that time. Starting from the reforms of 1978, the market was liberalised.

The capital markets in the country have advanced quickly, even during the tumultuous civil war. For example, Sri Lanka’s largest-ever initial public offering (IPO), Malaysian telecoms firm Dialog, listed on the exchange in 2005 during the height of the conflict. The IPO increased the bourse’s market capitalisation by 20%. The CSE has continued to upgrade its infrastructure, introducing an automated electronic clearing and settlement system – the Central Depository System (CDS) – in 1991. The CSE then introduced its Automated Trading System (ATS) in 1997, and automated surveillance was added in 2008. The regulator itself was established in 1987.

Post-War

Cheap money in the aftermath of the 2008 global financial crisis, and the end of the civil war, led to a boom in the financial markets in Sri Lanka, taking the benchmark Colombo All-Shares Index from a 2008 low of about 1500 to a 2011 high of nearly 7800. This was supplemented by the listing of over 60 IPOs in the post-war era. However, the country was unprepared for the rapid rise in equity prices, the increase in leverage and the general disorder during the bull market run. The regulators and the exchange tried to get a handle on the situation. Price caps and credit controls were introduced, while investigations were launched into suspicious market activity.

A drop in prices ensued, taking the index down from almost 7800 to just over 4800 between February 2011 and May 2012. While the Securities and Exchange Commission of Sri Lanka (SEC) worked to undertake investigations, it faced significant outside interference and no progress was made, according to local press reports. An element of “regulatory capture” is said to have been achieved by some investors. The pressures placed on the office led to a series of resignations and prevented the regulator from not only investigating wrongdoing but also developing a strategic plan.

The index did recover as confidence returned, but it started to slide again in the face of political uncertainty and international economic headwinds. The index climbed back to 7500 at the beginning of 2015 but dropped to under 6900 by the end of the year. At the beginning of 2016 the decline continued, with the benchmark index decreasing to 6400 by February, in line with many other emerging and frontier markets in Asia.

Delivery Vs Payment 

Since the rise of the new government in 2015, significant efforts have been made to improve the markets. Some are quite technical in nature, with safety and soundness key areas of focus. Stocks traded on the CSE currently settle using the T+3 system, and the exchange has not had problems with delivery failures. Nonetheless, settlement risk does exist due to the fact that cash and securities move at different times. In order to reduce this risk, the CSE is in the process of creating a central counterparty (CCP).

The new institution, which will be owned by the CSE, will guarantee cash and securities delivery and get the exchange closer to achieving true delivery versus payment, the global standard recommended by the International Organisation of Securities Commissions. In addition to bringing the market up to international levels, the CCP will allow for the listing of derivative products, according to Rajeeva Bandaranaike, the CEO of the CSE.

The target date for the new institution is 2017, according to press reports at the end of 2015, and total planned investment is LKR600m ($4.3m). The exchange chose BTA Consulting, a UK financial markets consulting group, to assist with the project. The CCP will be backed by the Settlement Guarantee Fund, which currently has assets of LKR750m ($5.4m). The CCP has been in discussion for a number of years, with a proposal being released and the project announced in 2009.

Upgrade

Other improvements have been achieved or are in the works. In 2014, the exchange upgraded the CDS, the first time in nearly two decades, its last upgrade being in 1995. The new system allows for improved trading of corporate debentures, permits the servicing of more asset classes, and makes the overall architecture more robust and scalable. The exchange will also be establishing broker back-office systems and order management systems to improve market infrastructure.

In May 2015 the CDS, signed a memoranda of understanding with the National Securities Depository of India. The two sides agreed to cooperate on matters related to depository and settlement. In early 2016 the CDS partnered with LankaPay, the national payments system operated under the guidance of the Central Bank of Sri Lanka. LankaPay will be digitising the cash settlement leg of the cycle, providing certification authority capabilities for the country’s four settlement banks, eliminating the need for physical signatures, hand delivery and physical documentation.

Exchange Changes 

In December 2015 the exchange adopted the Global Industry Classification Standard to classify listed companies. The standard was developed by Standard & Poor’s and Morgan Stanley Capital International (MSCI) so that there would be consistency in terms of industry definitions. In June 2015 the exchange also amended Rule 8.1 of the ATS, to reduce volatility at the daily close. Under the new rule, the closing price is determined by the last trade of 100 shares or more. On top of that, brokers are required to install telephone recording equipment. The CSE has been discussing an overhaul of listing rules, but no sign of the revision was published as of early 2016. It would also like to allow dollar listings and investments. Vajira Kulatilaka, chairman of the CSE, said that this capability would make the exchange more attractive to foreign investors who are interested in buying into equities but are have concerns about fluctuations of currency.

Additional reforms are now being suggested by the CSE. Small and medium-sized enterprise boards are one such possibility as well as a state-owned enterprise board, which would include companies of Sri Lanka’s Board of Investment.

The CSE has a vision, and it is ambitious; it has set a goal of $50bn market capitalisation, but, as yet, no deadline has been given. As of early 2016, the market capitalisation was $20.91bn, which represents only around 31% of GDP.

In addition to increasing the market size, the CSE also has ambitions to improve surveillance and governance, develop new products, reduce risk, strengthen market infrastructure, grow the investor base and develop institutional capabilities. Sri Lanka would ultimately like to become the financial centre of South Asia. “GDP and market capitalisation are misleading economic indicators for Sri Lanka,” Stefan Abeyesinhe, CEO of Asia Capital, one of Sri Lanka’s largest investment banks, told OBG. “GDP has been driven largely by construction, with little trickle-down effect to the population, and on the exchange most major government companies, from airlines to banking to telecoms, are not listed. These values, when reflected, would show the true value to an outside investor.”

The CSE is a self-regulatory organisation owned by its members, but demutualisation of the exchange has been discussed for some time. The Asian Development Bank first mentioned the process in 2002. Since that time, it has been on the agenda a number of times, and it was declared imminent in the past. Demutualisation is favoured because it will allow the public to get a stake in the exchange. In addition, demutualisation will also increase the independence of the market from the government.

Trading Trap

The market has suffered a great deal from the lack of new equity. Private companies have been staying away because of political uncertainty, economic difficulties and global challenges, especially with the rise of US interest rates. In general, large company listings are unlikely, as the enterprises most qualified to sell shares don’t need the money and would rather remain private, while those that are in need of capital would have a difficult time listing on the public exchange. Likewise, rules set forth by the SEC in 2014, which served to increase the minimum public float requirement, caused a number of firms to consider delisting, as reported by local media.

Participation in the stock market is low. Despite there being more than 750,000 accounts at the CDS, many of those are duplicates or dormant. In total, it is estimated that only about 25,000 accounts trade actively. It is a vicious cycle, as low participation makes the market less attractive to investors, leading to yet less participation.

Brokers must keep their rates high, discouraging much-needed trading. Fees are fixed for trades under LKR50m ($360,000), while a minimum floor rate is set for higher transactions. When all fees are added, for transactions up to LKR50m ($360,000), the total cost is 0.82%. The lack of trading limits the amount of research that can be produced. At one time Colombo attracted major regional brokerages and the quality of the work was at international levels. Now, the economics don’t justify that level of commitment to equity research.

Stock market participation could also be affected by the government’s recent announcement, in March 2016, of its intention to reintroduce capital gains tax in Sri Lanka in an amendment to the 2016 budget. The opinion of most market players is that the tax, if imposed on capital gains of stocks, will significantly constrain market expansion and reduce trading volumes even further.

International Interest 

The country has been working to attract international investors, undertaking various roadshows to introduce Sri Lankan equities to the world. These events, held in places such as London, Zurich and New York, have generated considerable interest. The Sri Lanka story is compelling to investors, given the end of the civil war and the change in government administration in 2015. It is also interesting because Sri Lanka’s economy is very different when compared with others, both locally and globally, and the market might be attractive because of this lack of correlation. 30% of the CSE’s turnover is foreign, most of which is from long-term investors, providing some level of insulation from external dynamics.

Local investors have noted, however, that only a few companies are highlighted in these roadshows, and they are usually the same blue chips that are already well known and the target of foreign investors. While international investors may be growing their interest in Sri Lanka, they are already well acquainted with the best opportunities and the roadshows may not make much difference to them.

One of the key steps in gaining more international interest is getting the market on a better MSCI list. Sri Lanka was downgraded from being an MSCI emerging market to a standalone market in 2001. It was upgraded to a frontier market in 2007, but the country hopes to return to emerging market classification. If it does so, it will automatically benefit from capital flow, as international money managers tracking the index buy stocks to maintain their portfolios. The country could also gain credibility from the classification upgrade, which could further help the market.

Privatisations

An important component of the development of the capital markets will be privatisations of the state-owned enterprises, as much of the economy is currently under government control and many of the relevant assets could be listed on the exchange. The passing of the State Industrial Corporations Act of 1957 and the Government Business Undertakings (Acquisitions) Act of 1971 resulted in 25% of GDP being generated by government entities by the late 1970s. A full 40% of the formal workforce was employed by the government. Privatisations began in 1989 and continued through a number of phases, with bus depots, plantations and industrial enterprises being sold off. However, over the last decade in particular, public sentiment and various corners of society have been largely averse to privatisation on a large scale. This resistance was fuelled increasingly by the rhetoric of the previous government.

In the 2016 budget finance minister Ravi Karunanayake mentioned that a number of assets would be sold on the CSE so that the government would be able to pay off some of its debt. The assets targeted include a number of hotels (Colombo Hilton, Hyatt Residencies, Waters Edge and the Grand Oriental Hotel), hospitals (Ceylinco and Lanka Hospitals) and Mobitel. The emphasis appeared to be on selling assets not considered strategic and staying away from more controversial sectors such as energy, ports and water. Other workarounds include selling shares to public sector employees, thus bringing government equity to market without actually undertaking privatisations. Public enterprises in the past have also seen some progress around the listing of subsidiaries, spearheaded in 2011 by Peoples Leasing & Finance, a subsidiary of the state-owned Peoples Bank.

SEC

Major reforms are taking place at the regulatory level. In 2015 the SEC said that it would be looking into allowing short-selling. At present, short-selling is prevented, but Vajira Wijegunawardene, director-general of the SEC, is contemplating the introduction of the practice – in which investors gain from falling share prices. The country is one of the few in the region that doesn’t allow for short-selling in some way, and the lack of that option is seen as an impediment to efficiency and a discouragement to international investment, as markets with liquidity and hedging options are usually preferred.

Sri Lanka has allowed short-selling in the past. Securities borrowing and lending has been permitted since 2002, but it was abandoned due to insufficient interest. Historically, one of the concerns regarding short-selling has been the lack of liquidity in the market. If share prices start rising, short-sellers may not be able to buy stock needed to square their positions if the float is limited, which is often the case in Sri Lanka.

The SEC is also taking aim at brokers in the country. Currently brokers are required to hold LKR25m ($187,500) in capital, but that will soon be replaced by risk-based capital minimums. The change for the country’s 28 intermediaries has been approved by the SEC and it is expected that the new requirements will result in mergers. The sector is in favour of the move, with the Colombo Stock Brokers Association saying that it approves of consolidation. It notes that because of competitive pressures and low margins, brokers are starting to ignore best practices and good policies, and that fewer institutions would be preferable.

In the 2016 budget Karunanayake said he was in favour of sector consolidation. During the boom years of 2009 and 2010 a raft of licences were issued and, as a result, the country has more brokers than is justified by the current volumes. The brokers are struggling and are finding it difficult to provide a level of service needed to encourage trading and investment. “There are too many brokers, and most find it difficult to survive,” Danushka Samarasinghe, COO and head of research at Sri Lanka’s Softlogic Stockbrokers, told OBG.

Boosting Surveillance

One of the top priorities in 2016 is the creation of a new SEC act. The current SEC act was enacted in 1987 and has been amended three times since then. It is expected that the new law will completely replace the old one. Sri Lanka also has a takeovers code, a unit trusts code, and various supporting SEC rules and regulations, as well as regular circulars, directives and guidelines issued by the regulator.

One of the expected moves under the new act is allowing the SEC to investigate both civil as well as criminal cases. Civil cases require a far lower burden of proof, and thus provide a stronger mechanism to curb market malpractices, a problem which is largely considered to be responsible for errant market participants in the post-war euphoria. The move should boost investor confidence while putting the SEC on par with international standards, as most regulators in the world are allowed to investigate a mix of civil and criminal cases.

Nevertheless, regulators have become quite active since the new government came into power. In June 2015 the SEC suspended the license of the Lanka Rating Agency (LRA). It had called for the rating agency to have an agreement in place with an international ratings company – as there were concerns about the LRA’s methodology – but the LRA failed to meet that requirement. The SEC has also suspended issues that are rated by the LRA, pending a rating by another agency.

In late 2015 the former chairman of the SEC, Nalaka Godahewa, was arrested on charges of corruption and fraud due to irregularities during the Rajapaksa years. He has also been accused of slowing corruption investigations. Three such cases have been reopened under the new government. In addition, the SEC has been reorganised to bring in additional human resources to handle the workload related to the reopened cases.

The prime minister has ordered an investigation into market irregularities between 2010 and 2014 and has called for the establishment of a serious frauds and financial crimes division. Additionally, he has recommended the establishment of a parliament-selected committee to conduct an inquiry.

Outlook

A foundation is being set for the future growth and development of the Sri Lanka capital markets, and many long-delayed reforms and adjustments are being undertaken. Once the new SEC law is put into place, short-selling rules are established, and new market infrastructure is up and running with the excesses of the past being dealt with, the country’s markets will be well positioned for capital raising and investment – both internationally and locally.

Going forward, Sri Lanka needs a few large IPOs to market. However, this might present a challenge given the difficulties of privatising state enterprises and the solid financials of the country’s private blue chips. Although, once a number of sizeable enterprises are listed, the country will be a good candidate for inclusion in the major international indexes, and that could have the effect of bringing the markets the momentum they need.