The big deal about capital markets
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Empty seats of brokers at a Colombo Office. Pic by Indika Handuwala
Sri Lanka’s capital markets are desperately in need of some firm policies and one could hope against hope that this industry could help move the economy away from the negative reliance on bank lending.
For many, it’s easy to dismiss the capital market as just one of the big ideas and a posh way of cash-rich aristocrats parking their excess money. But actually capital markets are a good idea with little in the way of concrete policies to back it up.
Strip away the politics, and capital markets could unlock trillions of rupees in capital to boost businesses and infrastructure, helping to kick start economic growth. It could raise so much cash for smaller businesses, and significantly reduce the costs to investors.
Size and liquidity puzzle
This notion to resurrect the capital markets should be based on breaking the link between the flaying economy and its over-reliance on bank lending. Banks are struggling to shrink their balance sheets after a lending binge in the past and as at now are reluctant to help companies borrow their way out of past trouble/raising capital.
This is an opportunity, but the problem is that our capital market isn’t deep enough to take up the slack. More than 30 years after the official launch of the Colombo Stock Exchange (CSE) and after more than three pieces of financial legislation in the draft form we still have no clear policy in order to boost the CSE and arrest this issue. The two major challenges facing the stock market are its smaller size and lower liquidity. “Solving this ‘size and liquidity’ puzzle is critical to unlocking the potential of the Sri Lankan stock market and requires very bold and visionary supply and demand side reforms at the level of the government,” an expert says noting that on the supply side, public enterprise reforms and listing of key commercial public-enterprises are necessary to increase the size of the stock market to a measurable degree.
On the demand side, pension reforms enabling investment of pension assets in broadly diversified portfolios that match subscriber risk and return preferences will generate sustainable demand for investing and trading in securities markets and help enhance market liquidity.
As is discussed for the past decades, he reiterates that a higher public float for listed companies and establishing a market making mechanism are necessary measures to enhance market liquidity. This too is in process, but again the progress is slow.
This invariably brings us to the argument of too many intermediaries in the stock market and brokerage industry consolidation. “Sri Lanka will also benefit from adopting a universal brokerage model where market intermediaries deal in all securities’ products,” the expert added.
Capital markets promote economic growth, employment, income and living standards. Sri Lanka needs a large amount of investments for various socio-economic development needs. The Economic Policy Statement made by the Prime Minister in the Sri Lankan Parliament on November 5, 2015 has identified generating one million job opportunities and enhancing income levels as the top two priorities.
Recognition alone won’t help
The government has recognised the capital market but is it enough? Achieving government objectives entail sizeable investments of private capital, both domestic and foreign. Developing the capital market will help mobilise funds needed to rally large investment needs required for Sri Lanka. With a strong capital market, both the private sector and the government will be able to effectively mobilise both domestic savings and foreign capital and channel them to productive investments which raise economic growth, employment, income and living standards with properly formulated and balanced development as well as distributional policies.
As one analyst pointed out, a capital market through a bond market can have access to income generating sections of the economy. “For an example, how can an investor get access to a toll highway income? Don’t forget provident funds want long term cash flows. They could buy debt raised against the toll receivable. If not the alternative is for one to put money in the bank and get less than inflation adjusted return and then the bank funds the project at a much higher rate and takes all the gains. In terms of risk if all projects were done by banks it means the risks are all with the banking system. That is why bond markets compliment the stock market and banking system,” he says, summing it all up.
The government has been depending on outside capital for investments which means higher premiums as the countries which lend to us (China) will view external sector risk and ask for higher premiums. “The capital market provides the platform for raising such capital and also the liquidity, that is required when one want to exit the investment,” the analyst says.
Sri Lanka’s capital market primarily consists of government securities, stock, and corporate bond markets which have a combined value of US$ 50 billion. The government securities market is the dominant sector with a value of $28 billion whereas the stock market capitalisation is $20 billion. The capital market is about 64 per cent of the economy with government securities and stock markets representing 35 per cent and 26 per cent of the economy, respectively.
All capital market experts say that despite many components of the capital market being in place, Sri Lanka needs to undertake substantial and challenging structural and policy reforms in order to establish a well-functioning financial system with more broad-based, efficient and stable capital market and to fully leverage its potential to achieve long-term economic objectives.
The first thing to do is to enact amendments to the Securities and Exchange Commission (SEC) Act. This will strengthen regulatory powers against securities law violations, allow demutualisation of the CSE and establishing a central counterparty clearing and settlement mechanism, provide for the development of new capital market products, and enhance investor protection.
As it stands this Act is in draft form and the SEC has uploaded it on its website for comments. All these steps were carried out twice before under different SEC Chairpersons. Let’s hope this time they’ll take all their steps forward.
A top capital market expert says that while there are plans underway to establish a separate trading platform for government securities and separate clearing houses for exchange-listed and government securities, serious consideration should be given to establishing a common trading, clearing and settlement infrastructure with appropriate legal and regulatory frameworks for both corporate debt and government securities.
Corporate bonds
While the primary market activity in corporate bonds which is hot in the news now has been propelled by favourable tax treatment, the secondary market is very inactive and illiquid. “It is necessary to establish conditions to make debt financing through the capital market more beneficial to companies than bank-based financing. Policy reforms to increase institutional investor participation in the listed corporate debt securities, and introducing a market making mechanism for listed debt securities are important steps for market development,” the expert says. This can’t be jargon for the authorities. While they too agree, what’s lacking is the vision. “They’re too busy running to the FCID (Police), balancing China and ‘trying’ to implement budget proposals,” is how another analyst put it.
Sri Lanka does not have derivatives or commodities exchanges and establishing these have been incessantly discussed, but to no avail.
The expert says that a realistic roadmap with proper sequencing of initiatives is needed before introducing derivatives and commodities. “Stock index futures, Treasury bond forwards and futures, individual stock options, and tea futures have the potential to play an important role in the initial development of derivatives and commodities markets.”
He says that Sri Lanka needs to significantly strengthen capital market knowledge and skills of market participants and investors across all capital market sectors including equity, bonds, unit trusts, derivatives and commodities. The financial market qualification system needs to be expanded to a multi-layered licensing framework to accommodate all asset classes and facilitate capital market development. Maybe they should start with the Treasury and the Parliament.
All market players call for a national level capital market development plan with participation and commitment of all key parties such as the Ministry of National Policies and Economic Affairs, Ministry of Finance, Ministry of Public Enterprise Development, SEC, Insurance Board of Sri Lanka, CSE and the Central Bank. Without the highest of level of commitment, the critical pieces of the capital market development puzzle will continue to remain unfinished, and any institutional-level master plans will continue to face implementation challenges, he says.
While getting all these parties into one table is critical, hopefully it won’t be a case of ‘Aandi Hathdenage Kenda Heliya’ situation, if it eventually happens. There’s still hope.