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Will Sri Lanka’s capital market change for the good in 2020?

03 Dec 2015 - {{hitsCtrl.values.hits}}

It is clear that an effectively functioning financial system will lead to increased competitiveness with economic growth, macroeconomic stability and poverty reduction.

The efficiency at which the institutions in the financial system mobilize savings, allocate funds to productive investments, monitor the operations of the entities and transform risk will largely govern the economic performance of a country.

In a social-market economy, the capital market performs the function of capital allocation. Without a capital market, it is virtually impossible to attract funds and efficiently allocate funds into wealth-creating projects.

A more broad-based and vibrant capital market is required for Sri Lanka to generate sustainable economic growth. To be most beneficial, the capital market must be able to function well, rewarding strong performers and encourage those who are unable to deploy capital effectively to align their strategies for effective utilization of resources. Well-functioning capital markets do a very good job of selecting the most suitable recipients of capital and ensure that those who obtained the capital, generate the returns or economic benefits.

When governments allocate capital, political clout replaces market returns as the basis for allocating the funds. Thus, when politics replaces economic considerations, more unprofitable and counterproductive investment projects that reduce the wealth of the nation rather than enhance it become the reality as we have seen in Sri Lanka in the past.

The experience of Eastern Europe and the former Soviet Union highlights the importance of the capital market. For four decades, the investment rates (as a share of GDP) of these countries were among the highest in the world.

The central planners of these countries channeled approximately one-third of the GDP into investment. Even these high rates of investment, however, did very little to increase their economic growth and the standard of living. Without the direction of a capital market, the investment funds were often channeled toward political projects favored by the politicians, rather than to important wealth-creating projects for the country.

Today’s challengers
In order for a capital market to function properly, there are several prerequisites. The participants are the driving force of the capital market, and provide the fuel that is needed to run the market.

Issuers, investors, and intermediaries will participate in a market if they see an economic benefit (low cost source of capital, higher returns), are willing (have the right attitudes) and able (financial literacy, regulatory safe guards), and are structured right as an industry to participate. The three elements of need/benefit, willingness, and ability to drive one another.

When benefits are clear and significant, investors will be less fearful and more willing to enter the market to invest their hard-earned savings, issuers will be more willing to do “costly” activities like disclosing information, and the intermediaries will be better skilled to provide proper investment advice. Market participation cannot be forced, but an enabling environment can encourage it. This environment consists of macro and political stability, including economic growth that generates a sufficient number of issuers, inflation and interest rate structures that are not too high or volatile, tax policies that do not disadvantage the capital market activity.

The lack of issuers who wish to tap the capital market with debt or equity issuances and offer sufficient liquidity to the market have been a key challenge. In order to encourage issuers, successive Governments have provided various tax incentives, which is not the best solution. Issuers need to see economic benefit in terms of reduced costs, new features they cannot get elsewhere such as larger volumes, quicker access and are willing to take risks & raise capital for their long term needs.

The capital market in Sri Lanka is under-owned by domestic investors versus its emerging market peers. Only 6.5 percent of the 3.1 trillion market capitalization of the Colombo Stock Exchange (CSE) is owned by institutional institutions such as EPF, ETF, Insurance Companies and Unit Trusts. The absence of a professionally managed non captive large institutional investor base in Sri Lanka is an enormous challenge. The main long term superannuation funds are largely captive and are saddled with conflict of interest. Most have been used for deficit financing the government budget and for politically directed investments rather than to serve the primary objective of generating long term retirement income for those who contribute. Insurance companies are unduly constrained by statutory liquidity requirements, investment directives that limit their exposure to unit trusts, equity and corporate debt markets. Retail investors alone usually cannot support the markets’ growth.

The diversity, size and professionalism of institutional investors will be the key in determining how fast and large the capital market can grow. Attempts to bring about pension reforms by successive governments have been scuffled by unions due to fear of the unknown, perceived concerns and lack of transparent stakeholder involvement.

The challenges for capital market intermediaries in Sri Lanka are huge and include pressures from clients, employees, shareholders and regulators. Over the last few years, the capital market industry has seen its collective brand suffer greatly. The negative publicity is just a symptom of broader challenges faced by the industry: fragmented subcultures, lack of true partnership between business and risk, as well as misaligned incentive structures that create conflicts of interest and disproportionately reward turnover to governance measures.

Capital market institutions today face difficulties ensuring their employees to act responsibly and in the best interests of their clients. Some businesses have struggled to live up to their fiduciary responsibilities and significant reputational damage and distrust has resulted. Establishing a strong culture of ethical conduct is essential to correcting these conflicts of interest and to restoring investor confidence. Their challenges include changing governance structures, lack of efficient and cost effective distribution channels, adoption of new technologies & meeting the required capital expenditures and attracting & retaining skilled talent.

Sri Lanka is still classified as a lesser developed “Frontier Market” with characteristics such as low market capitalization, low liquidity, and higher volatility warranting a higher premium for foreign investors to invest. The market infrastructure at the Colombo Stock Exchange (CSE) has not kept pace with developments at other stock exchanges in the region, in terms of trading and settlement systems and demutualization of the exchange. The CSE ranks Stock Broking companies based on Turnover and Trades with no effort being made to rank Stock Broking Companies based on more objective governance ranking or rating. On the other hand these factors indicate the opportunity for the Sri Lankan market to develop (with timely reforms) to the levels that most peers have been able to achieve in a shorter time span.

The Securities and Exchange Commission (SEC) is constrained with a 28 year old outdated Act with limited scope that can regulate only a few licensed market intermediaries and take only criminal enforcement action & compounding of offences against individual willful wrongdoers who have discredited the industry. Particularly, the current SEC Act does not provide adequate scope to impose necessary disciplinary sanctions against Registered Investment Advisors (RIAs) for violation of SEC regulations and who fail to act in accordance with their code of ethics and standards of conduct.

These are challenges that Sri Lanka cannot run away from and therefore needs to implement next generation reforms to get the capital market to function properly to play its intended purpose for the benefit of the society. The country needs reforms that do not overburden the efficiently run entities in both private and public sectors to offset and pull the weight of inefficient entities in the public sector where with the right reforms can turn out to be some of the largest wealth-creating entities for the country.

The vision for 2020
Looking forward to 2020, the capital market in Sri Lanka will play an increasingly important role in providing everything from financing the most successful companies to generating the investment returns needed to support an ageing population.

By 2020, with concerted efforts of public awareness and education campaigns emphasizing the need to reform the unions, investors would have clearly understood the greater good of long term investing for retirement with professional pension fund management. Therefore, the retirement savings system would be reformed to provide account portability and at least two or three choices as to how the funds are managed for the beneficial owners (i.e. individuals who contribute should have the flexibility to choose how their funds are managed and types of investments best suited to their respective risk profile).

Similarly, retail investors will have more financial literacy and right attitudes to seek proper investment advice, carefully evaluate the future potential of their investments and allocate their savings to capital market investments that provide best returns to commensurate with the risk they are willing to assume rather than blindly follow price movements. Minority shareholder rights will be enforced by Institutional investors such as Unit Trusts, Pension Funds, Insurance Companies using their proxy votes at listed company AGMs and EGMs to bring about a greater degree of market discipline.

The government would have had the political will and sincerity to undertake indispensable State Owned Enterprise (SOE) reforms to bring about a mixed ownership structure and more transparency, management efficiency and reduce the dependence on taxpayers.

This in turn would have led to the CSE being classified as a more developed and mature “Emerging Market” that is widely tracked by foreign investors and considered to be active and liquid than a “Frontier Market”. CSE would be included in the MSCI Emerging market Index with the listing of a few SOEs and many large & successful companies. As a result, a significant amount of foreign investors that replicate the MSCI Emerging market Index (tracked by investors managing about USD8 trillion in assets) would have invested in the Sri Lanka. Several new products such as Real Estate Investment Trusts (REITS) and Exchange Traded Funds (ETF), would have been listed in the CSE, providing retail investors wider flexibility and an avenue to gain entry into the real estate market with a small amount of capital and liquidity to exit. These would have led to increasing the depth and breadth of the market and increasing the market capitalization of the CSE as a percentage of GDP at least to about 50 percent.

Market Intermediaries would have addressed the reputational damage that they have suffered with zero tolerance for misconduct where leaders will have to ‘walk-the-walk,’ responding fairly and consistently to probe violations with regulatory compliance being refocused and emphasis on serving client’s interest first. To respond to regulatory and market criticism, market intermediaries would have to ‘change for the good’ and embrace a cultural transformation that fosters transparency and high professional standards while minimizing conflicts of interest.

These changes will increasingly become key value drivers and differentiators of the future as society assesses the social utility of capital markets and its participants. The ‘change for the good’, will restore confidence in the very institutions we depend upon for capital formation and economic growth. The stock broking industry would have transitioned into universal broking and become more viable with the consolidation of the industry with increased trading volumes and broking fees which are market determined.

Technology will be used as a tool by market intermediaries to gain a competitive advantage, as an enabler of innovation & change, to offer new products & services and cost reduction. For example, clients will be able to open new accounts by filling in more convenient electronic forms, monitor their investments, make & receive payments and receive all communications electronically using their smart phones without resorting to paper documents and cheque writing.
The business models of traditional capital markets participants will go through a fundamental shift to become more agile with the introduction of multi-asset class, integrated and in many cases, broker-neutral platforms for capital markets participants and their clients to use a single provider to trade in many asset classes. In short, technology will touch and transform business models in a vast array of areas, such as automation, less reliance on manual processes that are prone to errors and duplication, data management, market surveillance, cyber security, regulatory reporting, funding and alpha capture.

The regulators would have also embraced technology where ordinary investors could check at a CSE/SEC website where the regulatory compliance and governance of market intermediaries and individual Registered Investment Advisors could be easily verified before they deal with them similar to other countries.

CSE will be demutualized with a broad-based ownership structure and will have enhanced trading, clearing and settlement systems in keeping with global standards to mitigate settlement risks and counterparty risks. The establishment of a Central Counter Party (CCP) and Deliver vs Payment (DVP) will enhance the product range offered by the CSE.

There will be unwavering regulatory commitment to take rigorous action against wrongdoers, taking full use of the brand new SEC Act that provides regulatory oversight of all market intermediaries and power to impose civil & administrative sanctions against individuals as well as institutions to provide enhanced investor protection.

While regulators (and media) have largely focused on ‘social good’ regulation for the past several years, priorities will shift such that ‘capital market participant good governance’ will become much more important, as stakeholders and regulators become increasingly aligned through 2020.

In conclusion, it is reasonable expect a market capitalization of around USD 50 billion by 2020 from the current level of USD 24 billion. The assumption is that the market value will double during the next four years. It would entail unwavering commitment to inclusive reforms by all stake holders leading to pension reforms, listing of SOEs, and greater participation by institutional & foreign investors, regain retail investor interest due to greater confidence and trust on the capital market. Thus reaching the intended purpose of a properly functioning capital market where capital is put to productive use thereby contributing to economic growth and ultimately to the wellbeing of the society.

(Ravi is the Group Director/CEO of the Candor Group and is a Fellow Member of the Chartered Institute of Management Accountants, UK, and a Chartered Financial Analyst, USA and has an MBA from Monash University, Australia. He functioned as a permanent member of the Financial Sector Reforms Committee (FSRC), a Prime Ministerial Task Force. He was also twice appointed as a commission member of the Securities and Exchange Commission of Sri Lanka and was a Director of Sri Lanka Insurance and Chairman of the Investment Committee. He is also the President of the Colombo Stock Brokers Association, President of the Association of Alternative Financial Institutions and was also the former President of CFA Sri Lanka, President of ITESA & Vice President of SLASSCOM. The views expressed in the article are solely of the writer and do not constitute an opinion of the company or any association the writer represent.)

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Will Sri Lanka’s capital market change for the good in 2020?

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