Management challenges in the capital market

Monday, 14 July 2014 00:39 - - {{hitsCtrl.values.hits}}

An extract from Dr. Nalaka Godahewa’s presentation made to the Management Club on 8 July at the Galadari Hotel, where he explained the management challenges faced in the capital market in the past and such situations can be avoided in the future. Due to the prolonged internal conflict, particularly in the economic front we lagged behind most of our regional counterparts. Now we have got an opportunity again to catch up. We should make best use of it. During the first five years since the end of the war the Government focused heavily on infrastructure development. The new airports, new ports, new power plants, new highways, new water projects and the expansions of the telecommunication networks are all testimony to that effort. According to Central Bank data we have been maintaining about 7.5% GDP growth rate over the past four years. Average inflation is around 6% for the last five years. Per capita income has been rising at about 13% rate over the last 10 years. Unemployment rate is below 4.4%. Balance of payment is in positive territory with about $ 985 m surplus. The exchange rate has been quite stable during the last few years. These macro indicators definitely signal a positive trend.

With these improvements we can look at the future more optimistically. The central bank is predicting sustainable economic growth of around 8% for the next few years. To support that an investment level of about 33% of GDP is expected. In many countries the capital market plays an extremely important role in promoting and sustaining the growth of the economy. It is an important and efficient conduit to channel long term funds to enterprises. Capital markets can also provide a medium for risk management by allowing the diversification of risk in the economy. Financial crises The stock market crash of 1987 or ‘Black Monday’ was the largest one-day market crash in history. On 19 October 1987, the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That crisis which started from Hong Kong created a chain reaction and quickly spread across global markets. By the end of the month, most of the major exchanges had dropped more than 20%. The 1997 financial crisis struck many Asian countries with an unexpected severity. During 2008-2009 the world economy faced its most dangerous crisis since the great depression of the 1930s. It resulted in the threat of total collapse of large financial institutions and downturns in stock markets around the world. The crisis played a significant role in the declines in consumer wealth estimated in trillions of U.S. dollars, failure of businesses all around the world leading and even failure of some national governments No one has fully mastered as to how financial markets around the world operates. But with every crisis the world has leant how to reduce the systemic risk. Proper regulation of the capital markets is therefore a matter of utmost importance. SEC and CSE The Securities and Exchange Commission of Sri Lanka was established in 1987 under the SEC Act no 36. According to the Act the primary objectives of SEC are threefold. The protection of investors, ensuring that markets are fair, efficient and transparent and the reduction of systemic risk. The SEC Act has been amended several times in 1991, 2003 and in 2009 The capital market of Sri Lanka has a long and eventful history of over 115 years. Trading began in 1896 by the Colombo Brokers Association. The CSE was set up in 1985. By mid 90s CSE was one of the most sophisticated stock exchanges in the region. It was in fact the first exchange in South Asia to introduce scrip less trading in 1991 However due to reasons that we all know, the market didn’t reach its full potential during the next 20 years while the rest of region moved forward. Market capitalisation of the NSE in India at end 2013 was 1.4 trillion dollars. Singapore was $ 612 b, Australia was $ 1.4 trillion, Tokyo was $ 4.6 trillion, Hong Kong was $ 3.4 trillion, Malaysia was $ 526 b, Indonesia was $ 405 b and Thailand was $ 396 b. Unfortunately we couldn’t keep up with this tremendous growth phase of other securities markets in the region. Our market capitalisation is only $ 20.3 b, around 30% of our GDP. The regional average of market cap to GDP is 168% where as the world average is around 74%.This clearly shows that we have enormous potential to grow with right focus. Let’s reflect on what actually happened. When the market started crashing, focus shifted to fault finding. Anti market sentiments were high and retail investors started moving out. Panic selling and margin calls further contributed to the fall of the market. Investor confidence hit rock bottom. As a result of this whole saga, we actually lost about 3½ years of productive time since the end of the war which we should have spent on actual planning and market development.

Market development plan Nevertheless in November 2012, SEC and CSE along with other industry stakeholders unveiled a three-year market development plan. Usually referred to as 10-point action plan, it actually covers seven areas of focus. 1.Strengthening regulations 2.Upgrading infrastructure 3.Expanding product portfolio 4.Increasing market liquidity 5.Improving capital market awareness 6.Increasing foreign participation in CSE 7.Demutualising the CSE The good news is after about 1½ years of initiating these projects, the 10-point action plan is very much on target. Most of the work is already completed Today the overall PE of CSE is around 15%. The one year forward PE is about 11%. So overall we can say the market is relatively attractive for investors. The 2011-2012 losses are still haunting the retail investors. Large state funds are not yet active in the market to their full potential. Most companies still seem to have alternate sources of funding to support their expansions and new projects. The banking system has excess liquidity. Financial literacy still quite low in the country. The unit trust industry is not aggressive enough to exploit the opportunities. Awareness is still low amongst the corporate sector on the true benefits of listing. So what kind of improvement do we like to see in another 3-4 years? We like to see more IPOs in the market. We like to see new investors entering the market and the number of CDS accounts growing. We like to see unit trust industry working harder to reach the masses. Corporate debt market should continue its recent success and grow. We like to see a sophisticated capital market which adheres to highest international regulatory standards in Sri Lanka. Commercial hub If we want to truly become a commercial hub we must be ready to cater to the needs of other markets as well. If we take cue from a successful commercial hub like Singapore in order to make Sri Lanka attractive as a commercial hub, the business environment should be really open and vibrant. Some of the key attributes expected would be the Ease of Doing Business, effective laws and regulations, being free of corruption, technology readiness, health, safety and security standards and the professional workforce. All the stakeholders; government, corporate, unions, workforce, civil society, should collaborate to ensure that Sri Lanka will improve on these areas and become competitive in the sectors we have chosen to focus on. One of the biggest impediments to investments is the clutter in the legal system with several legislations overlapping each other More clarity may be required on the available mechanism to report red tape experienced by investors, investigate and take quick action where is the motivation for the public servants except self motivation? It will help the country a lot if there could be a mechanism to recognise and reward high performing government officials and departments If we want to be a commercial hub we may have to consider incentives to attract of head quarters and regional offices of international establishments to Sri Lanka. Skill development and capacity building will be a key requirement to support the evolving industry sectors which also need further reforms in the education sector. We need a bigger and stronger financial sector. Colombo should be a place where both local and foreign ventures can raise funds. Innovative financial instruments will be required to support the real estate and infrastructure developments. A greater engagement of the private sector is required to support the next growth phase of the economy. Most of these can be achieved and will be achieved. Question is how fast. Just because certain things look good for the economy we cannot just expect them to happen because we operate in a complex environment. The need to consider diverse views may sometimes slow down the decision making process. We need to accept that reality and be patient sometimes because there is no better alternative to democracy.