In Sri Lanka, as politics is inseparable with day-to-day life, it holds true for the link between political developments and the capital markets. With 2015 presidential elections now in the past, initial euphoria regarding the new president and the fresh government had ended with the market performance becoming choppy. Reality has set in, the new government is in office for only 100 days and the main focus of the ruling party policymakers would be to introduce the democratic reforms they promised within the said period.
With President Maithripala Sirisena informing he would be dissolving the parliament end-April provides a reality check that yet another new government could be formed in May depending on which political party secures the majority. Hence, till May, the uncertainty regarding the victor would remain; would it be a United National Party (UNP) government led by Ranil Wickramasinghe or would it be a Sri Lanka Freedom Party (SLFP) government led by President Maithripala Sirisena?
With this turn of events it is understandable that the policymakers would pay less attention to the capital markets at this juncture. But if the policymakers of the current government and the new government, which is to be formed after the parliamentary elections, are sincere about Sri Lanka’s economic development, they would also have to pay close attention to the current status of our capital markets and what reforms are necessary. This becomes ever so important in ensuring a secure and legal framework for securities trading, providing an exit route for foreign direct investments (FDIs), overall development of the capital market system and serve the broad aspect of investment promotion.
Back to basics, what is the purpose of capital markets?
With communism and controlled economies having become a theology of the past and the world having embraced capitalism (though to various degrees) capital markets have become almost a necessity. The primary function of capital markets is to provide a floor or in modern-day terms a platform for the transaction of equities and debt instruments. The nature of transaction could be both primary and secondary. The chief benefits of an IT-enabled capital market system would be of direct access to capital, ensuring liquidity for the holders of paper assets and most importantly price discovery with a greater percentage of accuracy relative to market forces.
Transparency and strict adherence to securities and financial law are expected to be vital factors in a well-governed and properly functioning capital market system, in which case would bring about many indirect benefits. If the macro situation is favourable (in relevance to other countries) and capital markets are attractive, foreign portfolio money would fly-in. Such bodes well in managing the country’s current account and though temporary would boost the foreign reserve position.
However, foreign portfolio money arrives with many strings attached, the fickleness of money manager thinking and vulnerability to relative performance of other nations would not provide assurance for the length of time global hot money would remain in one nation. Nevertheless, within an economy which has tangible sustainable growth, the positives of portfolio money flows far outweigh the negatives. Furthermore, a vibrant capital market system would provide more assurance and serve as a magnet of attracting real FDIs though influx of fly-by-night type of traders would be difficult to thwart.
Also many consider the capital markets to be a barometer of economic health of a country. Given the swift information flow, increased transparency in price discovery and been a platform to capture business and investment sentiment there is a certain degree of validity for this belief. However, in the Sri Lankan context, my belief is that the capital markets could provide a limited indication of the economic performance but cannot be considered as the overall economic pulse of the nation given the limited penetration of capital market activity along with regulatory imperfections which is influencing true price discovery of securities.
Therefore, I totally disagree with the thoughts such as the listed market should always be rising to reflect a better economy! Even in a situation where complete free market operations are allowed under the strict accordance to the securities law, the markets could move either way. Despite the economy doing extremely well, prospects becoming much better, the listed corporates providing exemplary profit growth, etc., still the All Share Price Index (ASPI) could lose value. This could be a resultant of prices been over heated and despite the prospects been good, the prices of listed equity would have to be pragmatic. Same applies to net foreign purchases since most often than not factors beyond Sri Lankan shores would affect investor thinking though macroeconomic direction of the island too would be closely focused.
Past five years of Sri Lankan capital markets
Much took place in Sri Lanka’s capital market space during 2010-2014 and I think I would not be wrong to say the last five years accounted for more noise, notice, negligence, arm-twisting, fragmented effort, regulatory clutter and actual effort than the past 20 years combined. Clearly there were many ups and downs but till now we did not have time to stop and reflect on these events in order to learn from the mistakes and truthfully understand what is needed to reform Sri Lanka’s capital markets.
Elation, following the complete end to the terrorist conflict, nitro-boosted trading at the Colombo Stock Exchange (CSE), gave only an upward direction. High-net-worth individuals (HNWIs) both seasoned and fresh entered the CSE and worked overtime to maximize from the bull market rally. The retail investors/traders also jumped into the market with unreal gains been actually achieved. It was mayhem for the pragmatic observer but a dream come true for all others who saw their share investments gaining significantly with over 100 percent gains within a few weeks.
The regulators, both the Securities and Exchange Commission (SEC) and the CSE, were clearly unprepared for this type of trading activity and were trying to take reactive measures to bring about some sanity to the markets. The market was flooded with both margin credit facilities and undue broker credit extended beyond any cover, while the grapevine created by a few brokers and HNWIs were in full throttle making the market bubble ever more bigger. The SEC tried to tame the madness by rightly opening investigations on flagged trades deemed flirting with the notation of market manipulation and securities fraud.
To break the unsustainable stock price boom, the regulator brought about price-caps, which was unpopular among many brokers, fly-by-night retailers and HNWIs. While acknowledging that better communication of the control measures and careful implementation of the same would have curbed opposition to price controls, in defence of the regulator I need to state that the urgency of the needed reactive mechanisms did not provide the time needed for detailed conceptualization and sturdy of the system. Since we should not forget the markets were going through a once-a-lifetime scenario of euphoria never experienced before in the country.
Further, credit controls were brought in, not just to contain the market bubble but to safeguard the entire industry and financial sector from an unprecedented meltdown and despite no praise came forth for both the SEC and the CSE, the regulators should be applauded for their efforts which ensured market sustainability. With these controls and the commencement of investigations on questionable trades sent the market into a nose dive and then a lull.
And the foreign investors also shied away since the HNWI and retail madness had driven the market beyond a 25x multiple, while my take was that true market value in 2011/2012 should have been around 17x and not beyond. With investigations getting tighter and the market bubble burst, a few HNWIs at the receiving-end together with a handful of participative brokers commenced their role of politicizing the SEC and intensified the definition of ‘Regulatory Capture’.
Despite all of the recent heads of the SEC been political appointees, changes became frequent. The last five years saw Indrani Sugathadasa, Tilak Karunaratne and Dr. Nalaka Godahewa at the helm of the SEC. Both Sugathadasa and Karunaratne had to leave their posts due to strong lobby by the regulated and the instructions of the President Mahinda Rajapakse, at least that is what I observe and the market believes. The reason boils down to investigations on errant trades.
The past SEC chiefs had both merits and demerits, while the most remarkable effort during Sugathadasa’s tenure was to create a dialogue among the industry and try to develop a strategic plan for capital market development. However, she too with Karunaratne had to pay the price for not dropping the investigations on securities fraud. In the recent times Karunaratne had been the most favoured chief at the SEC, by its officers, for the simple reason he let the experienced and qualified officers to do their job.
He did not try to bulldoze his opinions; he let the institution run itself and wanted to do the correct thing which was also the success behind his leadership. If there were negatives during his tenure, it was that he was selective in his communication with the industry because of which the open discussions with all the market participants suffered. What is wrong is wrong. The manner in which Karunaratne was humiliated in front of the industry by the then head of state was unwarranted and it was because he was doing right, at least by the SEC and the public.
Politicization of the market and the SEC had reached a different scale while making the SEC just an extension of the highest echelons of political power. Karunaratne resigned and Chandu Epitawala, who was responsible for the ongoing investigations, too rendered his resignation due to utter frustration and serious lack of governance on the part of the regulator. (While at the time I expressed my regrets in writing, I still believe the industry they served owe them a public apology). Then Dr. Godahewa took over, with the challenge of balancing the situation.
The on-going 19 investigations were stopped and the market was given confidence of an end to the prevailing lull and sharp index growth along with higher market capitalizations. But in credit to Dr. Godahewa, he increased communications with the industry, expedited efforts on amending the SEC Act, with the support of the CSE strategized in reducing systematic risk by moving towards a Delivery Vs. Payment (DVP) and a CCP system. But other than which all other efforts were synonymous with the scenario of regulatory capture.
Many regulations such as credit controls were relaxed to propel the ASPI growth. Many more situations of questionable and manipulated trades were given a blind eye by the regulator, though at the expense of the affected retail and minority shareholders. The SEC entered the new avenue of marketing Sri Lankan equities and co-organised worldwide roadshows. All 28 brokering houses, all of which are privately owned, were provided subsidies to attend these investment roadshows. Targets were set by the SEC and not the CSE to increase the number of listed securities.
Pressure must have been on to shore up the ASPI and increase trading to please the power echelons. However, the index did rally and the market liquidity improved though the instigator was not the SEC nor the CSE but the reported strong gross domestic product (GDP) growth, market stagnation for closer to 15 months, actual reduction in market interest rates and the increased focus on frontier markets by global portfolio investors.
Unprecedented levels of regulatory capture in Sri Lankan capital markets
I credit my knowledge on regulatory capture to a colleague of mine who has served the Sri Lankan capital markets for many decades. Investopedia defines regulatory capture as:
“Public interest agencies that come to be controlled by the industry they were charged with regulating are known as captured agencies. Regulatory capture is an example of gamekeeper turns poacher; in other words, the interests the agency set out to protect are ignored in favour of the regulated industry's
This phenomenon is not limited to the SEC but would be visible among any public body. And in Sri Lanka where politicization has taken a new meaning, it is nothing short of gamekeeper turned poacher. At the SEC this is evident by the way the institution had got its priorities mixed up.
Many economies and their respective securities watchdogs had gone through this phase and in developed economies industry lobbyists had been too strong while allegations of regulatory capture are still widely discussed. However, if we are to be a progressive nation we need to learn from others’ experiences and leap-frog to better regulatory environments which foster sharp, free and sustainable growth. Market regulators need to understand their respective responsibilities and boundaries while respecting the same of the industry and keeping in mind their primary stakeholder is the public at large.
The SEC should be free of vested interest and the institution should be allowed to operate on its own without intervention. The primary task of the SEC is none other than enforcing the securities law by way of surveillance, investigations and legal action. If the legal framework is in order and the SEC itself follows strict governance protocol, the market need not be artificially propped up but would be on an automatic growth path. Policy creation and strategic development initiatives would be the next most important function of the regulator but without the primary function in operation the rest becomes meaningless.
Assisting in capacity building also could fall under the purview of the securities watchdog. Marketing of listed securities and having investor conferences either locally or internationally is not within the mandate of the SEC. In essence, the SEC is a public body and their primary stakeholders are not the investors, brokers, traders, etc., but the public of Sri Lanka who may or may not be involved in the local capital markets. Therefore, their task should be to ensure legal regulation of all traded securities and policy development for the betterment of the capital market system.
What is needed for a futuristic capital market system in Sri Lanka?
Speaking on behalf of the industry, we need to shy-away from the attitude of ‘need not do anything, the market is going to go up thus should not disturb the apple cart, etc.’ If we need to nurture a strong, robust and larger capital market system capable of propelling Sri Lanka into a regional economic/trading hub, some amount of shock treatment is needed. The industry and brokers should be ready to weather a brief period of discomfort with a few months of market and index lull in the event the industry becomes hypocritical but on the flipside, if the change is taken favourably, the market may not suffer at all.
Clear segregation of duties and responsibilities of the SEC and CSE is a must. The securities watchdog should not be involved in marketing, providing valuations, etc., but needs to carry out its core responsibilities. In a fast-growing economy and in a capital market system, which is close in gaining emerging market status, the importance of the SEC is paramount. I believe the SEC for it to carry out its role swiftly and in efficacy needs to be an independent body (as it is supposed to be) rather than be part of a larger institution such as the Central Bank. Though in some developed markets, Financial Services Authority (FSA) serves as the watchdog for all financial services industry, such a broad and common regulatory framework may not be the call-of-the-day since such could unsettle the much-needed efficacy in a fast-growing economy.
As mentioned many a times, the strict impartial enforcement of securities law is the most crucial requirement. And that is what is required since 1 percent of the industry participants may be flirting with the law but the balance 99 percent are honest and abide by the law of the land. To quote a few personal experiences, many a times a countless number of large international portfolio managers have mocked the operations of the market regulator, frequent changes at the SEC, back and forth policy directives with regard to credit, penalizing officers who are honest, blatant protection for some investors and brokers, having a deaf-ear to minority shareholders, covering up fraudulent activities of a few listed companies, how many wrong doers were punished last year?, etc., were some of the criticisms voiced in a light mannered way.
Needless to say I tried to dodge the questioning and sarcasm citing that there are issues in many developed markets as well…but in all honesty I know that the concerns are real. And the most difficult question is when the seasoned foreign investors ask us, “what is the watchdog doing marketing stock?”
Any investor seeks to make profit, so if anyone spots an opportunity which seems to be of future value they will step in. It is the same for capital markets, therefore as long as the proposition sounds profitable within a well regulated legal framework, there would be many takers governed by demand and supply. Therefore, regulators need not try to spoon feed foreign investors and attempt to parade the success as their own. For many decades individual brokering houses have been conducting overseas road shows and marketing events, promoting Sri Lankan stocks amongst the global investors.
And throughout history the CSE has been more of an institutional market where foreign portfolio trades account for near 30 percent of market turnover. There would be many who would be privy to what I am stating since foreign trading activity was robust at the CSE since the 90s. Also even during the years of war, a few brokers and analysts continued to market Sri Lankan equities and ensured foreign activity at the CSE was high, foreign trading accounted for over 50 percent of total market turnover in 2008 and 30 percent in 2009.
Therefore, if macroeconomic stability prevails, the growth outlook remains intact and the CSE is relatively attractive vs. other investible markets, foreign portfolio money would land at our shores. Also having targets for number of listed companies and capitalization is meaningless and more of a marketing gimmick, since there is no point inviting each and every boutique shop to be listed at the CSE. If the framework is strong and there are benefits to be gained by listing, private institutions would come-forth to be listed.
New product initiatives, broadening the types of securities tradable at the CSE, obtaining broad consensus on amending the SEC Act, ensuring legal enforcement of the prevailing securities legislature, advocating benefits for listed companies and developing frameworks for stae-owned enterprises (SOEs) to be listed and more importantly creating a strong foundation is needed to take Sri Lanka’s capital markets forward.
On this basis I have segregated my thoughts on capital market development under market operations, listed entities and new products.
*Independence and impartiality of the regulator needs to be ensured by strengthening the institution without making the SEC vulnerable to personal agendas.
*Capacity building at the SEC is necessary while attempting to thwart the departure of senior and experienced SEC officers. Even consider bring back of officers who left their post due to duress. (Such would help the overall growth plan since their expertise and experience in the said task would shorten the implementation cycle).
*Pending investigations need to be re-activated to ensure the health of the system and bring back lost confidence of the institution.
*Confidentiality of transaction details and investment portfolios needs to be ensured. (It would not be a surprise if there are employees of either the SEC or CSE on the payroll of influential power brokers/dealmakers, since similar situations prevail in other markets. But action needs to be taken to mitigate such possibilities).
*Regulator money should be spent on building the institution (not by way of brick and mortar) but improving governance within, surveillance and investigations, learning and sharing of best practices of other regulators, increased communication with the public with regard to improved state of the institution, continue to build industry capacity, educate the public on capital markets and securities fraud, showcase credibility by way of action.
*Brainstorming sessions by the regulators with the market participants would be a progressive move in developing or amending policy framework.
*It would be great if the CSE can further develop their IT platforms and link the same with the banking network, enabling online settlements for securities transactions. This may be plausible only for local investors but the efficiency gains and possible growth in participation levels could be significant.
*Brokering industry needs to consolidate, since the 28 broker model is not sustainable. However, regulator involvement in such should be minimal, all brokerages are private institutions and their shareholders should decide the future of the same.
*Investment research is important in making markets efficient, however recruiting, training and retaining quality analysts would be costly. Thus, discussions should take place to seek avenues for brokerages to expand their research product and make it economical.
*The CSE currently been a mutual exchange has limited gains by conducting overseas roadshows, while better use of resources could be thought of. The scenario may change in the event demutualization becomes firm and the process is publicized. Till then best is to let the *brokering industry do their overseas marketing…after all that’s why brokerages exist, to market tradable securities both locally and internationally.
*I am an advocate for maintaining higher transaction fees - not only brokerage but the other government taxes, the CSE fees. However, increasing fees may not be the way forward though the current negotiated brokerage for high-value transactions could be revisited. Therefore, if not increase at least the current structure needs to be maintained. It was unwise for our capital markets to reduce transaction costs especially way ahead of time even before the economic and market revival had begun. I believe my argument is warranted since marginally higher transaction costs are not too much of an ask for a fast-growing economy having a natural real GDP growth rate of near 6 percent
*The CSE and SEC also can play a much active role in providing comparative data on fund management companies which invest in the listed market. Public awareness should be created on individual fund performances (with respect to pension, mutual and investment funds accepting public money) which would pave the way for better management of public money through healthy competition.
*Though it may be beyond the purview of the capital market regulators, the Sri Lankan capital markets would positively benefit if the state-run pension funds - namely the Employees’ Provident Fund (EPF) and Employees’ Trust Funds (ETF) - are managed independently using competent professionals incentivized on market rates and performance success. While these funds enjoy a windfall of private sector employees’ money, they should be mandated to disclose their entire holding on a quarterly basis. Such action would improve accountability and better the fund performance.
*Also the entire capital markets industry and the private sector employees should lobby for the freedom of selecting a pension fund of their choice, to contribute the 22 percent of their salary on a monthly basis. This would propel an unprecedented growth and create healthy competition within the fund management industry, which would invariably have a positive impact on the capital markets and the overall economy.
*Attracting more listings need to be done through incentives while the same benefits need to be provided for the existing listed entities. From the listed entity point of view, many options have opened up for capital raising and if the sole purpose of listing is for raising money, the question needed to be asked is, would the trade-off between fresh capital and complete public disclosure be a beneficial one for the company?
*Listed companies need to allocate significant management resources for the provision of information. While they are bound to meet analysts and provide public disclosure of all their financial performance on a timely manner, the benefit they receive is just the ability to raise capital through the market and perceived prestige. More tangible benefits should be offered to listed companies by way of preferential corporate tax rates vs. their unlisted peers.
*Public listing of companies in an emerging economy assists in accountability, social responsibility, positive competition and creating larger and stronger institutions.
*If the policymakers consider the alcohol and tobacco industries to have negative social impetus and already tax them at a punitive tax rate, the regulators should lobby towards making it mandatory for any company engaged in these industries to be listed. This methodology would provide a level playing field for all operators of the said industry and force strict social responsibility and public awareness.
*I personally think imposing minimum free-float requirements for already listed entities and considering case-by-case exemptions on the said regulation may not be the best way to increase market liquidity levels. But a more productive and market-friendly move would be to entice corporates to maintain a minimum free-float through preferential tax rates.
*I believe plans are being envisaged to capture the trading of government debt securities (T-bills and bonds) through the CSE. This is a much welcome move. More than any benefit for the CSE, the key aspect of such a move would be to bring about transparency and an increased level of price discovery for government securities trades within the secondary market.
*While we have been lobbying for derivative products in the past, following the learning from the 2008 global financial crisis, the Sri Lankan capital markets could be better-off without derivatives. The brokerage income and increased liquidity levels would be the benefits of derivative products but these could become toxic and pose undue market risk.
*Intensified lobbying and public awareness should be built around the listing of the SOEs. Even if the policymakers decide in favour of privatization or not, the minority stakes in SOEs still can be listed which would be an automatic route for more public disclosure, healthy competition, better benchmarking and accountability. Even in a privatization process, such been channelled through the CSE would mitigate negative outcomes experienced in the previous privatizations of Air Lanka and the state-owned LP Gas Company.
*An ambitious and futuristic plan would be to develop a commodities exchange within the CSE. The Sri Lankan economy is too small to have multiple exchanges and such a move would only lead to duplication and waste of resources. However, despite being ambitious, the CSE could devise a plan in cohesion with the main agricultural produce brokers and even open up discussions to enable a multi-asset exchange.