Sri Lankan Regulator Explains Country’s Capital Markets Turnaround Strategy
At the 66th CFA Institute Annual Conference held in Singapore in May, I had the honour and pleasure of interviewing Nalaka Godahewa, chairman of the Securities and Exchange Commission (SEC) of Sri Lanka, on the development of the country’s capital markets.
Godahewa started with a bit of history. He explained that since the end of the war in 2009, the stock market (as measured by the All Share Price Index, ASPI) has grown by approximately 6,300 points (or 420%) within a span of two years — from 1,503 points in December 2008 to 7,797 points in February 2011. However, the rise was unsustainable. As most investors did not have a good understanding of the market dynamics, speculation for short-term results became the order of the day. Given the volatility, regulators reacted by introducing several new directives that were seen as ad hoc by stakeholders. With market sentiment remaining negative, the market eventually collapsed in February 2011. This, in combination with investors voicing strong negative opinions about the state of the market, eventually led to the resignation of a number of senior SEC staff, including two of its chairpersons. The ASPI bottomed out in May 2012 at 4,832 points and has since recovered about half of the losses from its post-collapse peak at 6,444 points.
Godahewa was appointed chairman of the SEC on 28 August 2012. Known for his turnaround skill, he has steered Sri Lanka Insurance into a leading insurer (recording more than 30% growth) and revitalized Lanka Hospitals to become an industry benchmark for service excellence in health care at an affordable price. He is also credited for the successful introduction of a master plan for the tourism industry and for efficiently running the administration as head of tourism. Not afraid to voice his opinions and take a stand on matters of principle, he has resigned from three of four chairmanship positions he held as part of his responsibilities at Sri Lanka Tourism.
Shortly after taking the helm at the SEC, Godahewa started a consultation process with the industry to understand the problems and remove a number of ad hoc regulations. In November 2012, the SEC, together with the Colombo Stock Exchange (CSE) and key industry stakeholders, unveiled a 10-point plan to revitalize the capital markets.
These points can be broadly summarized into four categories:
The first area is to improve the liquidity of the market. Godahewa explains that this starts with increasing the participation rate of foreigners, educating retail participants about investing, and communicating well with the media. One of the problems in the past, according to Godahewa, was due to misinformation being fed to the public, thus leading to the negative sentiment. He hopes that this education process will help rebuild investor confidence and double the local participation from 700,000 to 1.4 million Central Depository System (CDS) accounts by 2016. The next step is to increase the market capitalization of the CSE. Sri Lanka has many successful companies in both the private and public sectors; currently only 5% of these companies are listed. Tax incentives and the growing need for financing are the likely catalysts to encourage these companies to list. Godahewa hopes to increase the numbers from 287 currently to 400 in 2016, with market capitalization increasing from US$20 billion to US$50 billion. Finally, to create market depth, he hopes to grow the unit trust market where funds will be managed professionally and also create growth in the fund management industry.
The second area is to improve the market infrastructure. With docile markets over the past 20 years, trading systems are currently outdated. In order to meet the needs of market participants, he intends for an upgrade in the system’s technology to be of a global standard by 2016. This would include strengthening the risk management processes, enabling centralized clearing for counter-parties and instituting a delivery versus payment settlement solution for securities.
Enablers of Capital Market Development
The third area is to enable the capital market to develop. One weakness of most capital markets in Asia is the lack of a corporate debt market. Traditionally, companies prefer to use bank financing for their operations. The same is true in Sri Lanka. Although the government securities market is 1.6 times bigger than the equity market, the corporate debt market is only 5% of the equity market. To encourage the development of this market, several concessions were given in the 2013 budget. Godahewa believes that a five-fold increase in corporate debt issuance from US$2 billion to US$10 billion within the next three years is possible. This, together with allowing other products (like the derivatives and commodities markets) to develop and demutualizing the CSE to foster a commercial agenda, will help sustain market interest.
The final category is in the area of market integrity. How do investors know that they won’t get taken for a ride if they invest in Sri Lanka? This is especially important given the perception of market manipulation activities surrounding the fall in the ASPI in 2011. Godahewa explains that since taking over the role, investigations have been conducted into alleged practices of market manipulation. He further emphasizes that the investigations found little evidence of such activities. Most of the cases were due to a lack of market understanding and overreliance on speculation. A vigilant surveillance system exists, according to Godahewa. Should there be suspected market misconduct occurrences, there are procedures in place at the SEC for a thorough investigation process.
One limitation he observes is the long time taken for enforcement actions to occur. This is due to the lack of provisions for civil and administrative sanctions in the current SEC Act. Addressing this concern, he says that a key component of the 10-point plan is amending the SEC Act — specifically, to manage misbehaviours by capital market participants is in the introduction of civil and administrative sanctions that will complement the existing route of using criminal action against offenders. Widening the choices will enable enforcements to occur in a more calibrated manner, consistent with the degree of the offence.
While the SEC’s plans are ambitious, it is generally good for the market. As of May, net foreign inflows amounted to approximately US$104 million. The contribution of foreign investors (only 24% at end 2012) has already grown to 40%. As with all plans, the success lies in its execution.
Photo credit: iStockphoto/kulicki