Sri Lanka's prolonged peace dividend

Sri Lanka's SEC chairman explains why his country's stock market will continue to grow strongly, driven by privatisations and the introduction of Reits and derivative products.

Colombo's stock market has been on fire since Sri Lanka’s civil war ended.

From $3.7 billion at the end of 2008 the country’s market capitalisation has grown five-fold to almost $24 billion now, according to CIMB research. In that time, it has been the world’s second-best performing market, putting on almost 400%.

For Nalaka Godahewa, chairman of the Securities and Exchange Commission of Sri Lanka, that is just the beginning. By 2020, he expects the total value of companies listed on the Sri Lanka stock exchange to be nearer $100 billion, with government privatisations at the forefront of a new listings drive.

FinanceAsia caught up with him in late November at his office in Colombo's World Trade Centre.

Is the ending of the war the main reason for Sri Lanka’s stellar performance?

Yes, largely. Since the war ended our performance has been second only to Venezuela. Back in the 1990s Sri Lanka was one of the most sophisticated stock exchanges in the region. In the early 1990s, for example, we were the first in South Asia to introduce scripless trading. Then unfortunately the rest of the region marched ahead and we got left behind due to the prolonged internal conflict here.

But since the end of the war, the market has done exceptionally well. The [benchmark CSE] index has risen from 1,503 at the end of 2008 to 7,275.68 today. And there has also been a big valuation re-rating, with the average [price-earnings] ratio rising from 8.9 to 17.3 times.

The unit trust industry has also witnessed a big expansion. It’s grown about 1,000 times and generated average annual returns of about 35%.

Has the performance been in a straight upward line?

No, growth hasn’t been consistent. In the immediate aftermath of the war, the market expanded very rapidly. It doubled between 2008 and 2009 and then doubled again between 2009 and 2010.  The peak came in 2011 and over the following 18 months, the market fell back.

Why’s that?

The immediate post-war growth rate just wasn’t sustainable. At its peak, the market was trading around 29 times forward earnings, which wasn’t at all realistic at that point.  A lot of domestic retail investors viewed the ending of the war as an opportunity to make a lot of money. They’d been trading on margin and when the bull-run started unwinding, they panicked.

The pain lasted about 18 months, but from the end of 2012 onwards we’ve been back on an uptrend again. The difference this time round is that both the market and investor base have become a lot more sophisticated.  We’ve also got a very advance surveillance system in place. The market is being constantly monitored and we respond to early signs of potential manipulation. Prevention is always better than enforcement action later.

So what’s your future growth forecast?

We will grow because the economy is continuing to grow. Our market cap is currently about 37% of GDP and by 2016 we expect it to reach 40%. At the end of war, it was only 11%. 

We have ambitious targets for 2020. The country is aiming to be a $150 billion economy by then and we would like our market cap to hit $100 billion. Our market cap to GDP ratio will then have risen to the 66% level. We expect to achieve this through organic growth, new listings, an expansion of our product portfolio and possible cross boarder listings.

During the last few years we’ve conducted foreign roadshows in Hong Kong, Singapore, Mumbai, Dubai, London and the New York. Every time we engage on a marketing campaign, foreign inflows increase. During the last three years there have been more than $900 million in net foreign inflows. About 32% of all trading is now by foreign investors. It’s slightly down from its peak of 40% in 2012 but that’s because the domestic retail base has been growing faster.  However, that’s still very small too. So our growth potential is high.

And yet, Sri Lanka still doesn’t seem to be on many people’s radar.  It’s not talked about in the same breath as Vietnam, for example.

One of the main reasons people haven’t quite noticed us yet is because we are still classified as a frontier market. Average daily trading volume is about $9 million, which is still not that large. Remember we lost almost 20 years of growth opportunity fighting an internal conflict through to 2009. So there’s a lot of catching up to do.

In order to get ourselves upgraded to emerging markets status, we need one or two large listings to expand the market capitalisation. That should happen in the next one to two years.

How many IPOs have been listed on the exchange this year and what kind of size have they been?

The number of listed companies has jumped by about 50 since the end of the war and we now have 293 listed on the main board. But most of them are small-to-medium-sized. There are only a few companies with a market cap above $1 billion.

There’s a lot of interest from foreign investors but their main complaint surrounds liquidity. We’ve tried to address this. Last December we introduced a new regulation giving companies two years to get their free float up to 20%.  At the moment almost one fifth of companies have less than 20% of their equity listed and some of them are our biggest companies.

The other way liquidity will increase is through new listings. Around 50 new companies are in the pipeline and will come over the next three years.

This includes some big government-owned entities. They’ve been waiting to see which way the market will go and they think the time is now right to prepare for listing.

Which government entities are top of the list?

Sri Lanka Insurance Company should be listed towards the end of 2015, beginning of 2016. It will be a $1 billion market cap stock. We don’t know yet exactly what percentage will be floated but it will be minimum of 25% as per main board requirements.

One large power plant is also being discussed. This was one of the conditions of its initial capital raising. The catering arm of Sri Lankan Airlines is also a possibility, as is Mobitel, the cellular arm of Sri Lanka Telecom.

What about more companies from the private sector?

We’ve been talking to them but they’re finding it very easy to source funding from the banking sector at the moment. Interest rates are low and bank liquidity is high. What will change is their desire for international exposure.

As the economy expands further, they’ll start looking overseas to expand and that’s when they’ll think about coming to the equity capital markets to raise capital.

What other kinds of new products are you targeting to broaden the market?

Our lack of a proper CCP (Central Counterparty Clearing) has previously limited us from expanding our product portfolio. We’re now rectifying this in a joint project with the central bank and Colombo Stock Exchange. It should go live towards the end of 2015, or early 2016.

At the moment, about 96% of trading is equity-based but CCP will facilitate an expansion in our product base. We want to start introducing derivative products.

I believe you are also thinking about Reits?

Yes, we are. Anyone who comes to Sri Lanka can see the infrastructure development taking place here – particularly the introduction of a proper highway system. We now need to start building new townships around these roads – housing, parking, shopping malls etc. Young people need housing and given our land limitations, we’d like to encourage more apartment-style living. The country has 65,000 square metres of land but we need to share it with our abundant wildlife. So we need to expand skywards.

Reits can provide a solution for our infrastructure development needs. We are hoping to make property an allowable asset class for the unit trust industry so we can broaden investor participation in the property development industry.

Is this property development coming from the private or public sector?

It’s initially likely to be government entities as there aren’t any big private sector property developers in Sri Lanka. We’re thinking of a possible partnership between the Urban Development Authority (UDA), the Railway Department and large pension funds.

The UDA and Railway Department have a lot of land, which could be used for development purposes. Funding could come from pension funds such as the Employees Provident Fund and Employees Trust Fund. After financing the initial construction phase, they can use Reits as a mechanism to broaden the ownership base and realise their investments.

How is this development going to be packaged up into Reits?

We’ve studied Reit models around the world and taken advice from both the Singaporean and Indian regulators. But what we really need to do is to come up with our own model for greenfield projects. In the developed world, most Reits are rental-generating assets. But we are looking at a mix between rental and capital gains because the Sri Lankan people prefer to own rather than rent their properties.

Some of our social housing projects are already under construction. We might be able to convert some of these into Reits. If that’s the case then we could be looking at our first Reit in the next one to two years. For the completely new greenfield projects it will be more like three to four years.

What kind of issue sizes are we talking about?

I’d say about $50 million to $100 million initially.

I get the impression that Sri Lanka would quite like to emulate Singapore in many aspects.

Well we’d like Sri Lanka to become a capital markets hub for the South Asian region. Sri Lanka is the one country, which is on friendly terms with every single country in the region and we’d like to make it easy for regional investors to raise capital here.

We’ve been very strategic in our approach. In November 2012, we introduced a Capital Markets Development Plan, which covers 10 specific initiatives. The current plan includes the introduction of CCP, amending the SEC act and the de-mutualisation of the CSE.

We’re just finalising the next phase of our 2020 development plan and this should be published in January.

How are you encouraging the financial services industry to expand here?

We’re thinking of establishing a universal licence system covering stockbrokers, margin providers and unit trust players with Chinese walls between each business. We want local players to get bigger and we’d like to encourage more involvement from foreign brokers.

How many foreign brokers are there at the moment?

There’s four out of 28 in total. But there’s been plenty of interest in buying existing local brokerages. This is something we actively encourage. There aren’t any ownership restrictions and we are increasing minimum capital requirements soon. I believe that will encourage smaller local brokers to either partner with a foreign player or sell to them.

And what of the corporate bond market?

It was very small until 2012 when we removed all taxes including a 10% withholding tax on interest income. This led to 400% growth in 2013. But again, it is still very small with less than $1 billion in outstandings. But we believe bond market will grow exponentially in line with other markets. By 2020, we hope it will rise to about $20 billion.

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