Sri Lanka’s stock market is facing two major challenges. One of them is its small size and the other, low liquidity.
Solving the ‘size and liquidity’ problem is imperative to unlock the potential of the stock market and requires very bold and visionary supply and demand side reforms by the Government, President Association of Alternate Financial Institutions and Immediate Past President, Colombo Stock Brokers Association, Ravi Abeysuriya said.
“The government should consider pension reforms as vital to the development of the country. The long-term growth of capital markets of Sri Lanka critically depend on demand side reforms to generate local demand for securities. When investment funds are allocated by the government political influence replaces returns as the basis for allocating the funds,” he said in an interview with Business Observer.
However, he said that the market has been volatile and showing a declining trend. We have only about 23,000 active investors at present, he said.
Excerpts:
Q. What is the status of the stock market and what needs to be done to make it function properly and attract more local and foreign investors?
A. The market has been volatile and showing a declining trend. We have only about 23,000 active investors (defined as at least four transactions per year).
The local institutional and high net worth investors have been out of the market for more than three years. We have had a net foreign outflow (more foreign selling than buying) of USD 10.4 million in the first six months of 2018 compared to a net foreign inflow (more foreign buying than selling) of USD 142.9 million in 2017.
Our stock market is facing two major challenges; they are smaller size and lower liquidity. Solving this ‘size and liquidity’ problem is imperative to unlock the potential of the stock market and requires very bold and visionary supply and demand side reforms by the Government. On the supply side, public enterprise reforms and listing of key commercial public-enterprises are necessary to increase the size of the stock market.
On the demand side, pension reforms enabling investment of pension assets in broadly diversified portfolios that match subscriber risk and return preferences is required to generate sustainable demand for investing and trading and enhance market liquidity.
Q. How will the country benefit from public enterprise reforms and listing of key commercial public enterprises?
A. The Government has significant ownership interests in some of the most important economic entities in the country including banking, insurance, savings, home mortgages, energy, aviation, pharmaceuticals, and plantations.
Significant and multiple benefits can be obtained for all stakeholders as well as Sri Lanka’s capital market by listing of State Owned Enterprises (SOE’s) in the Colombo Stock Exchange (CSE).
a) Once these are listed this would increase the CSE market capitalization. International fund managers usually measure the total market capitalization of a country as a percentage of its GDP as well as the absolute USD value.
Sri Lanka remains stagnant due to size constraints as we have not been increasing the market capitalization of the CSE which is at 23 percent (India 95%, Vietnam 74%). Listing of SOE’s would be beneficial as this would allow greater recognition for Sri Lanka as a frontier/emerging capital market.
b) Whatever the regime in power, SOEs have continued to incur enormous and persistent losses and the citizens unknowingly pay for these losses by way of taxes.
A majority of citizens having seen so-called privatizations of some SOEs done in the wrong way (given them to political henchman at highly undervalued prices and having lost jobs) are generally against privatisation.
The need of the hour is to stem the bleeding in SOEs and bring in private sector governance and management practices to SOE whilst continuing state ownership.
Even profit making SOEs could improve their performance substantially if the governance issues in SOEs are addressed. Listed entities are mandatory required to follow governance standards such as, establishing a proper nomination process for the appointment and screening who is appointed as chairpersons and board of directors of SOEs, having professional management, financial discipline, performance monitoring and progress review of key performance indicators (KPIs), effective internal controls and risk management, among others.
c) It would be a requirement for regular filing of financial accounts in a timely manner for these SOEs under the stringent listing rules and reporting requirements of the stock exchange.
Thus, the public will get to know if and when political theft happens and when politicians use SOEs as a means to solve unemployment problems through ‘sponsored employment’. Further, auditing of financial statements should be done without delay and more accountability will be created for these entities.
d) Employees of SOEs will also benefit generously from Employee Share Option Scheme (ESOP) that can be offered to get the employee buy-in and commitment for better performance of SOEs.
e) Well-run state-owned enterprises (SOEs) will be able to borrow funds through the issuance of securities in the capital market thus reducing their reliance on the government for financing needs. Listed SOEs will then be able to raise more funds by way of additional equity and debt offerings to the public and further reduce the budgetary burden of the Government.
Q. Why do we need pension reforms?
A. The government should consider pension reforms as vital to the development of the country. The long-term growth of capital markets of Sri Lanka will critically depend on demand side reforms in order to generate local demand for securities.
When investment funds are allocated by the government political influence replaces returns as the basis for allocating the funds. As a result, investment projects that reduce national wealth rather than enhance becomes the reality as Sri Lanka has amply demonstrated by political boondoggles and high visibility projects favoured by politicians. Pension reforms play a critical role in channeling retirement savings into long-term wealth-creating projects, where the entire economy will significantly benefit with increase capital productivity and higher income in the long term.
In Sri Lanka, the two mandatory and state-managed superannuation funds dominate the pensions industry. For example, the Employees’ Provident Fund (EPF) investment portfolio consisted 91.3 % government securities, 4.2% stocks, 2.1% corporate debentures and the remaining 2.4% in fixed deposits as at end 2017.
The problem with EPF is that it has provided a low return i.e. an average of 11.5 % per annum for the period 1980 to 2017 to members. When compared with the average Treasury bill yield, which is the short-term risk-free benchmark and the average annual inflation per annum of 10.4% for the same period, the real rate of return from EPF of 1.1% (11.5% less 10.4%) over the period, is quite small.
Therefore, the monthly saving of 23% of the salary over the working life of the contributors will not grow to an adequate sum where the final withdrawal amount would be enough for a comfortable retirement.
The returns paid to contributors are also low compared to the risk of investment portfolios. The funds did not pay a risk premium to contributors beyond the short-term risk-free rate although the portfolios of investments consisted of assets such as Treasury bonds, corporate bonds and equities that are long term and are more risky than short-term Treasury bills.
Therefore, it is important to consider creating more broadly diversified portfolios subject to the investment constraints to optimize the risk-reward structure of these portfolios.
Q. What pension management reforms do you recommend?
A. The private sector provident fund schemes with one-size fits all approach, do not provide investment options with different risk-reward structures to their subscribers.
All investment decisions are taken by the funds. The lack of choice inhibits the creation of portfolios with varying degrees of asset allocation across different asset classes to suit subscriber preferences.
A key aspect of pension reforms should involve offering portfolio choices to subscribers and creation of investment portfolios based on subscriber choices. Alternative risk-reward structures that match investment risk and return preferences of contributors will contribute to more activity in the secondary market as well.
Subscribers can be offered three portfolio choices such as a Gilt Fund (Treasury bills and bonds), a Corporate Debt Fund (Corporate Bonds) and a Growth Fund (equity)whose returns are benchmarked against indexes.
The subscribers will have the choice to decide what percentage of their monthly contribution goes into which fund rather than mandated by the Government.
This approach will also yield greater long-term benefits as the subscribers will become more educated about investment choices over time, contributing to the development of a more knowledgeable and educated investor base.
Considering the excesses in equity and bond investments that have transpired it is imperative that the management of provident funds in Sri Lanka is free from political interference and investments made by the funds are fully transparent to the contributors.
The funds should be managed by professionals with skill, competence and diligence and are committed to their fiduciary duty and place contributors interest before their own.
They should be well paid and be supervised by an independent oversight investment committee to ensure proper procedures and policies are followed when making investments to prevent them being enticed by bribes and corrupt practices resorted to by unscrupulous companies to amass large profits as was done in the past.
It is, therefore, imperative that the Government strengthen technical capacity, knowledge and competency of in-house fund management of the statutory contractual savings institutions. The capacity building needs may involve establishing investment policy frameworks and policies, portfolio management expertise, and infrastructure and ICT systems for fund management operations.
Q. What trend would we see in the stock market within the next five years?
A. Over the past few years, the stock market has seen its collective brand suffer greatly. The lack of investor confidence is just a symptom of broader challenges faced by the industry.
If the government unwaveringly implement the above reforms that have been proposed by capital market experts many a time, our Stock market too will have regular and sustainable demand for securities and will go a long way to develop a large, liquid, vibrant and sustainable stock market.
It is no accident that robust capital markets are a defining feature of every advanced economy. Sri Lankan companies too will be able to grow into corporations with continental and global reach upon which Sri Lanka’s prosperity rests, where our capital market provides them with necessary long-term debt and equity capital.
Q. What are your views on stock market development initiatives?
A. Markets only work when participants believe they are fair and transparent. The Securities and Exchange Commission of Sri Lanka (SEC) and the Colombo Stock Exchange (CSE) are in the process of implementing far-reaching reforms. They include, a brand new SEC Act, setting up of a clearing house for settlement of securities, depository and demutualisation of the Stock Exchange, introduction of new financial products such as Exchange Traded Funds (ETF), Real Estate Investment Trusts (REITS) and Derivative securities, that I am confident will be implemented as they are within the preview of SEC and CSE.
However, unless government implements public enterprise reforms and pension reforms concurrently with other SEC and CSE reforms Sri Lanka will have a sub-optimal capital market, like a half-baked cake that nobody can eat. As the history has shown many a time, whether the current or future government will have the political will and insight to carry out the essential reforms required to make the country prosper remains a question.