It may rank as the smallest constituent of MSCI’s Frontier Markets Asia Index behind Vietnam and Bangladesh, but Sri Lanka is a country with ambitions to stand alongside bigger rivals.
It wants to join the index provider’s benchmark Emerging Markets Index and has set itself a three-year timeframe to do so according to Rajeeva Bandaranaike, chief executive of the Colombo Stock Exchange (CSE), in an interview with FinanceAsia.
Fund managers could be forgiven for taking this with a pinch of salt. MSCI’s most recent release shows Sri Lanka now has a 6.62% weighting in the MSCI Frontier Markets Asia Index and does not even feature in the top six country weightings of its global Frontier Markets Index.
It is also not the first time stock market officials have espoused grand ambitions and then failed to deliver. Under the previous regime of strongman president Mahinda Rajapaksa, the country’s Securities & Exchange Commission head, Nalaka Godahewa, confidently predicted Sri Lanka could achieve MSCI Emerging Markets status by 2015.
When FinanceAsia went to visit him in November 2014, he forecast the CSE’s market capitalisation would rise from its then $24 billion level to $100 billion by 2020 following a string of government privatisations. He believed this would boost market cap to GDP from 37% to 66% over the same time period.
Instead things went rapidly backwards and the privatisations failed to materialise. Today, the CSE has a market capitalisation of $18.96 billion and average daily trading volumes have halved from their $6 million level in late 2014. The equity market now represents just 22% of GDP.
However after two difficult years, 2017 witnessed a turnaround in the exchange’s fortunes. Ironically, it was the MSCI’s decision to upgrade Pakistan to EM status, which boosted foreign portfolio inflows.
Under Bandaranaike’s tutelage, the exchange is also forging ahead with sweeping structural changes, which should provide firm underpinnings for a much bigger market that can release Sri Lanka's undoubted potential. As ever, the swing factor lies with the government and a privatisation programme, which will need strong leadership to overcome vested interests in maintaining the status quo.
However, the current coalition government under President Maithripala Sirisena and Prime Minister Ranil Wickremesinghe, is frequently criticised for lacking any kind of can-do attitude.
Its inability to execute policies quickly enough for the masses and even bigger difficulties communicating their long-term benefits in a readily understandable manner, are two of the main reasons both coalition parties lost heavily in local elections last week.
After confidently writing off Rajapaksa, Colombo’s educated urbanites were left deeply shocked when his new Sri Lanka Podujana Peramuna (SLPP) party won 239 out of 340 seats. Many had expected the coalition parties to lose ground given the country’s frustrations.
But they did not expect a complete walkover for a man who styles himself as a populist, but has been widely accused of deep-seated corruption and human rights abuses.
Will the elections act as a wake-up call for the divided, technocratic government? How will this affect the CSE’s plans to develop a broader market? In the following interview, Bandaranaike explains why actions speak louder than words and how the exchange may finally be coming back into its own at a pace, which makes sense for its long-term development.
So Sri Lanka wants to join the MSCI EM Index?
We’re aspiring to because we’ll automatically attract larger foreign fund flows (editor’s note: the MSCI EM Index had $1.6 trillion in benchmarked assets as of June 2017 compared to less than $10 billion against the Frontier Markets Index).
But actually that’s almost a secondary consideration. Striving to get into the index automatically raises the bar because there are certain minimum criteria that have to be met covering governance, risk, liquidity and size, accessibility of foreign investment and exchange control regulations.
This will help us to improve. In three years, we will be operating at a higher level than we are today.
You know, sometimes it’s better to be classified as a frontier market because it means a higher allocation of funds. Today, we’re competing against Vietnam and Bangladesh, whereas in the EM world we would be up against much bigger guys.
So I think we’re in the right place at the right time. When Pakistan was recently upgraded, funds re-balanced and we benefited from that.
We had record inflows last year in rupee terms: just over Rs110 billion ($707.3 million) compared to Rs70 billion in 2016. The difference was even more marked in terms of net flows: Rs17 billion compared to Rs300 million the year before.
Funds also rotated to Sri Lanka because the market is relatively cheaper in P/E terms and is trading around 10 times current year earnings.
How many companies meet the MSCI EM size and liquidity criteria of just over $1 billion?
Just one company (John Keells Holdings), but we need at least three. That’s where the listing of state-owned enterprises and large private sector listings will come into play. So part of the plan has to be attracting SOEs to list.
It’s a chicken and egg situation. If we get that size of companies onto the market then prices and valuations will rise and more private sector companies will see the value of listing.
How feasible is it that this will happen given what’s going with the coalition government?
Yes it’s a political question and whether the political will to push these reforms through exists. At some point, these state-owned institutions will have to reach out to the capital markets for their funding requirements, even the profitable ones.
For example, Basel III requirements will push the banks to increase their capital. They cannot just depend on the government for the money. We have to give these entities the freedom to go out and raise money.
So the listing of state-owned banks won’t result from the government divesting stakes?
The requirement for capital will be the greater need.
They will use multiple sources to raise capital. We are also looking at a multi-currency board so local companies can raise foreign capital. The Central Bank has agreed to it in principle and we’ve submitted the rules to the regulator. We should be able to activate it during the first half of the year.
There are already a few companies, which have expressed interest in dual listings as well including one company in the Maldives.
That means we shouldn’t expect much from a government privatization programme then?
They’ve already identified some non-strategic entities to be listed such as Lanka Hospitals. They’ve also called for expressions of interest in the Colombo Hilton and Grand Hyatt. The Hilton deal should be comparatively large since it used to be one of the top five listed companies.
A couple of hotels won’t make much of a difference to liquidity though, will it?
It’s a start.
I believe you're also launching an SME board.
The motivating factor there is also about access to capital. There are a lot of private equity investors getting into start-ups and this platform will give them an exit mechanism. We’ve got regulatory approval and are waiting for final clearance.
We should go live by the end of the first quarter. We’re planning a first series of workshops with the International Finance Corporation (IFC) to get this board moving.
What’s the ratio of foreign to local investment in the stock exchange?
Foreign investors account for about 50%, with local institutions about 25% and retail the remaining 25%, although most of them are high-net-worth individuals. Real retail is probably about 10% of the overall market. What we’d really like is a one third split between each constituency.
Wouldn’t EM status make that even harder to achieve as foreigners could come in and swamp the market?
No, because it you look at our track-record domestic institutions used to be in the market. It’s a question of getting them back again and that’s the toughest nut to crack.
A lot depends n the external environment. Right now domestic institutional investors prefer fixed-income instruments because rates are high.
And the Central Bank can’t reduce rates because the currency slipped after the election results came through?
Exactly. That is one key dependency in our quest to increase market volumes. Foreign investors want higher liquidity and we want captive sources back into the market. We feel that’s critical for the valuation multiple to increase.
In the meantime, we want to broaden the market and are doing a lot of investor programmes for retail investors. There are several unit trusts, but brokers do not have branches out in the regions like banks do, so accessibility has been a key issue.
We have a couple of strategies to address this. Digital access is growing among the younger population.
The new SEC Act will also license agents working in the regions on a commission basis. We’re currently working on a model and policy framework. We hope to formulate the rules for this by the end of the year.
One of the biggest game-changers for the CSE will be demutualisation, splitting ownership rights from trading rights.
Yes the bill has been issued and will shortly be put to parliament. It should go through parliament quite quickly. We then have one year to complete the documentation and legal process to convert. There’s also a legal requirement to list ourselves in three years.
We have already prepared ourselves to become more commercially focused and are developing a new business model.
I believe brokers aren't happy with the proposed 60/40 ownership ratio?
The ratio is already decided, but is still open for debate in parliament. Right now there’s a perception that we are broker driven exchange. It may not be a reality. Demutualisation means we will be able to shake that perception off. Brokers will become a minority on the board and independent directors a majority.
What are you doing to improve technology and risk, another MSCI criterion?
We’re moving to Delivery Versus Payment (DVP) in phase one and Central Counterparty Clearing (CCP) in phase two. We started CCP in 2014 but the next year, the Central Bank pulled out of the project, which would have established common clearing including government and corporate securities.
We had re-group and that set us back in terms of time. But we recommenced with a new two-phase plan.
We’re looking at a nine- to 12-month timeframe, so realistically it will be the first quarter of 2019 when phase one is fully operational. The broker community are now ready technologically. Their back office systems are in place. So too is the order routing system.
We’re currently in the process of talking to brokers and custodian banks about how to make our margining and custodian systems operational. Then we need to put the right IT in place for that. We’re most likely to upgrade our current system.
Stock borrowing will come with DVP and then we’ll be able to introduce derivatives with CCP.
How long will phase two take to execute?
We’ve got some more legal requirements to sort out before we can set up a clearing company and counterparty guarantees. But it won’t necessarily take longer than phase one.
We also need the new SEC Act. It’s been submitted to parliament and was due to be debated in January. The elections set that back a bit, but we expect it to be re-scheduled some time this month.
How will the SEC Act improve governance, another MSCI requirement?
The SEC will be empowered to enforce the regulations. For example, once the act is passed, they will be able to levy penalties against miscreants. They will also be able to launch civil actions rather than criminal ones, which require a higher burden of proof.
What have you been doing to improve access for foreign investors?
We need to strengthen and make the whole account opening process a lot shorter as it can take a couple of weeks end-to-end. We’ve already managed to significantly shorten the timeframe at our end.
Before the middle of last year, it probably took a couple of weeks and now it's down to a couple of days. But we need to work with the custodian banks to shorten the period at their end.
It should be fairly straightforward as it’s a matter of sharing the know your customer (KYC) data. At the moment, it’s replicated across a number of different entities including the central bank and brokers.
We also need to improve post trade confirmations, which are still done manually. We want to initiate straight-through processing (STP) so everyone is connected.
We are on Swift and so are the banks. The next step is to get the brokers on as well and we’re working with Swift to come up with an affordable solution for them.
Once that happens, we maybe able to shorten the settlement cycle from T+3 to T+2.
And what about exchange controls?
Well we don’t have free convertibility. But Foreign Exchange Act has helped in that direction. So there have been changes, which will have a positive impact on the MSCI criteria.
One of Sri Lanka’s big ambitions is to set up an international finance centre. How will it help the CSE?
It will give us a tremendous opportunity to introduce new products and play in that space. It’s still a couple of years off because the government needs to do enact more legislation, so we don’t yet know exactly how it’s going to be formulated.
At the moment, there’s Dubai and Singapore, then nothing in between. But we have to mindful that we need to give investors a reason to come. So the regulations need to change, facilitating free convertibility so investors can bring capital in and out.
How is that legislation progressing?
Is it moving forward, but a lot of work has to be done.
How have the local elections impacted the government’s ability to execute it?
Well, the elections were for local government so the balance of power in parliament has not changed. What I will say is that the political landscape is always changing.
