Towards development of Sri Lanka’s corporate debt market

Introduction

The corporate debt market is the widely-used term in Sri Lanka, for the private sector debt securities market. The corporate debt securities generally include short term debt instruments, such as commercial paper and long-term debt securities such as private sector securities (corporate bonds) with maturity of one year or more.

The corporate debt securities can be classified into floating rate and fixed rate instruments, secured or unsecured and public offered or privately placed. A developed private sector debt securities market could provide a stable source of finance when the equity market is volatile and resource requirements of the corporate entities are large.

The issuance of debt securities by the private sector entities results public benefit both at the macro-economic level and at the micro-economic corporate level. Because of widespread government budget deficit situation globally, it is possible to generalise that governments are unable to finance the massive investment required for national infrastructure projects.

At the corporate level a proper mix of equity and debt is vital for efficient corporate growth under normal business circumstances. Without debt financing, the growth of the corporate sector would tend to be constrained.

The private sector enterprises have two basic means of financing; from securing loans from banks and by issuing bonds in the capital market. Corporate debt securities, especially bonds with maturities of more than one year, are generally cost effective for long-term, large-scale and opportunistic financing by issuers with a high credit rating. Meanwhile, bank loans are cost effective for short-term, small-scale and recurring finances by borrowers with a lower credit rating or without a credit rating.

Corporate finance theory shows five categories of benefits from private sector bond markets. They can:

• Diffuse stresses on the banking sector by diversifying credit risks across the economy
• Supply long term funds for long-term investment needs
• Provide long term investment products for long-term investment needs
• Endow financial products with flexibility to meet specific needs of investors and borrowers
• Reallocate capital more efficiently.

These are the features that should emerge as an economy develop, grow and poised to enter into the status of a middle income level country. By providing long-term, fixed-rate, local currency funding private sector debt bonds help reduce the market interest rate, foreign exchange and refunding risk and contribute in mitigating the kinds of problems that brought about the Asian financial crisis in 1997.

Market in Asia

In recent years, the expansion of the corporate bond market in the Asian region has been receiving attention. The progress made however varies widely across countries. South Korea, Malaysia and Thailand have made reasonable progress in this regard. Both China and India have surprisingly lagged behind.

A number of factors could be adduced for the slow growth of the corporate bond market in the Asian region. These are:

• There are only few corporate entities in the region which are capable of meeting requirements in terms of transparency and governance standards.
• The public offering of corporate bonds is expensive, time consuming, hampered with tedious procedures. Accordingly, corporates have been finding it easier to borrow from banks or make a private placement for their bonds.
• Corporate bond market has been an institutional market involving over the counter bulk trading making the trading activity less transparent
• Non availability of bankruptcy laws to ensure investor protection has also contributed towards the slow development of the corporate bond market.
• Corporate governance and disclosure standards available in the countries do not provide enough confidence to investors to go in for investments in bonds
• Building the infrastructure required for a developed corporate bond market to function is subject to time and resource costs.

Authorities can support the development of the private sector bond market by maintaining a ‘well functioning’ market for government securities and by helping to establish disclosure procedures and a credit rating system for private sector securities, bankruptcy laws and avoiding public sector crowding out.

Sri Lanka-Present Scenario

As a country within the Asian region we should question ourselves, what is the progress that Sri Lanka has made in this regard. In Sri Lanka the corporate bond market was inactive in 2011 according to the Central Bank’s Annual Report.

There was one solitary issue of debentures amounting to Rs. 1 billion listed on the Colombo Stock Exchange in 2011. The issue was offered both at fixed and floating interest rates. In addition four debentures were issued in the market by way of an introduction.

The trading turnover of debentures on the Debt Securities Trading System of the Colombo Stock Exchange (DEX) was Rs. 2.7 billion in 2011. Listed bonds are not actively traded in the DEX system. A critical mass of market makers or bond traders are conspicuously absent in our market.

The absence of an ‘exit route’ has led to a ‘hold investment to maturity’ culture among the investors of corporate bonds which has deterred the long-term corporate bond issuance in the market. The inference that can be drawn from the market statistics is that the corporate bond market has been one area which remains the least developed of all the segments of the capital market for reasons known to the market participants.

Intermittently the topic of how to develop the private sector bond market is discussed, seminars held, reports written and press releases made but interest soon tends to fizzle off due to absence of follow-up, not making plans and low commitments by authorities and stakeholders.

Notable positive features

Yet, when you compare Sri Lanka with other Asian countries, we seem to have reasonable necessary and sufficient conditions to build a vibrant corporate bond market. Sri Lanka has the legal framework in place to provide for regulatory oversight and investor protection. It has a fairly developed financial sector segment of the market which is reasonably free of controls. It also has quite a few corporate entities and even State-Owned Enterprises which could take advantage of the bond market for their requirement of financial resources.

In terms of the country’s track record, the development of a functioning government securities bond market have preceded that of the private sector bond market and this is a favourable pre-condition for the government securities market to facilitate development of a private sector bond market.

In this context, it is prudent and timely, to enable the primary dealers of government securities to deal in corporate debt. Here I am considering their current knowledge levels, skills and their regulatory capital requirements, which makes them an ideal candidate to assume the role of an active market maker of corporate debt.

Another element essential for the development of the private sector bond market is the credit rating system is in place. The other elements, the disclosure systems and bankruptcy laws, need to be strengthened but are possible to be completed in the short-run if we are committed to the task at hand. Sri Lanka has the required infrastructure the depositories for scrip-less issuance, recording and book keeping up to the beneficial ownership level, the trading platforms namely the DEX, the transaction clearing infrastructure and risk mitigated fund settlement system – the Central Bank owned and operated ‘LankaSettle’ system and a sophisticated national payment system. We have a system of credible system of credit rating agencies.

Over and above the required skilled human resources a spin-off effect of the established mature government securities market is also available. The trading, clearing and settlement technology is not strange to us in view of the market familiarity of the scrip-less depository environment and DvP settlement mechanism of government securities market since year 2003.

Way forward: Connecting the individual components

My observation is that, by and large, the individual components to develop a vibrant corporate debt market are currently in place in Sri Lanka. If this fact is acceptable then connecting these individual components and establishing the arena for the capital market to develop and thrive should not be a very difficult task.

Against this background we need to analyse then, why are we passive in the need to develop this segment of the capital market. Is it not in the radar of the authorities? Are we engrossed in lesser issues which constrain all parties from proper focus on the big picture of capital market development and maintaining financial system stability? Is it the lack of leadership and ownership? Lack of commitment among stakeholders? Lack of coordination? Financial resource constraints? Or any other reasons?

 Answers to these questions, from those who are close to the capital market will help to make a fresh attempt to create a vibrant and a dynamic corporate debt market in Sri Lanka which in my view is very essential in taking us through the journey in order to take the GDP of the country to the US$ 100 billion platform.

In the meantime, I wish to place a few features which could be added to the project of connecting the individual components which was mentioned above;

1.Taking appropriate measures to widen and deepen the bond market. This could include enhancing the investor base, introducing a class of market makers and sorting out other issues at hand.

2.Address the anomaly in the risk reward structure of government bonds with private debt securities; lifting the 10% withholding tax for corporate bond.

3.For the Colombo Stock Exchange to develop a system that is more conducive for debt trading as the present DEX system is an investor level system and not a dealer level system. It is a dealer level trading system which is the priority need to drive the traded volumes.

4.The unlisted bond market is presently under the regulatory purview of the Registrar of Companies (at the primary level) and this should be considered to be brought under the purview of SEC.

5.Currently there is a requirement to issue a prospectus for each issue. A shelf registration scheme can be considered to be created for frequent issuers who will only be required to publish the issue related information.

6.Establishing optional platforms to provide facilities for on-line public offerings in different ways to investors and a scheme of repurchase agreements in corporate bonds to enhance liquidity of bonds

7.Once the domestic segment of the exchange fully stabilises, an international segment to be considered for listing of Asian bonds to facilitate the Asian country issuers to undertake their trading activities.



(The writer is a commission member of the Securities Exchange Commission, Company Director and former Deputy Governor of the Central Bank. The views expressed in the article are solely those of the writer and are not those of the SEC, the Ministry of Finance or the Central Bank.)