Govt. policy reforms imperative to develop stock market

By Ravi Abeysuriya

Sri Lanka stock market is facing two major challenges; they are smaller size and lower liquidity. Solving this ‘size and liquidity’ problem is imperative to unlock the potential of the stock market and requires very bold and visionary supply and demand side reforms by the Government. On the supply side, public enterprise reforms and listing of key commercial public-enterprises are necessary to increase the size of the stock market. On the demand side, pension reforms and facilitating digital transactions with a digital ID is required to generate sustainable demand for investing and trading and enhance market liquidity.

How will the country benefit from public enterprise reforms and listing of key commercial public-enterprises?

The Government has significant ownership interests in some of the most important economic entities in the country including banking, insurance, savings, home mortgages, energy, aviation, pharmaceuticals, and plantations, among others. Significant and multiple benefits can be obtained for all stakeholders as well as Sri Lanka’s capital market by listing of viable State Owned Enterprises (SOEs) in the Colombo Stock Exchange (CSE).

a.) Once these are listed this would increase the CSE market capitalisation. International fund managers usually measure the total market capitalisation of a country as a percentage of its GDP as well as the absolute USD value. Sri Lanka remains stagnant due to size constraints as we have not been increasing the market capitalisation of the CSE which is at 23% (India 95%, Vietnam 74%). Listing of SOEs would be beneficial as this would allow greater recognition for Sri Lanka as a frontier/emerging capital market.

b.) Whatever the regime is in power, SOEs have continued to incur enormous and persistent losses and the citizens unknowingly pay for these losses by way of taxes. A majority of citizens having seen so-called privatisations of some SOEs done in the wrong way (given them to political henchman at highly undervalued prices and having lost jobs) are generally against privatisation. The need of the hour is to stem the bleeding in SOEs and bring in private sector governance and management practices to SOE whilst continuing state ownership. Even profit making SOEs could improve their performance substantially if the governance issues in SOEs are addressed. Listed entities are mandatory required to follow governance standards such as, establishing a proper nomination process for the appointment and screening who is appointed as chairpersons and board of directors of SOEs, having professional management, financial discipline, performance monitoring and progress review of key performance indicators (KPIs), effective internal controls, risk management, among others.

c.) Additionally, it would be a requirement for regular filing of financial accounts in a timely manner for these SOEs under the stringent listing rules and reporting requirements of the stock exchange. Thus, the public will get to know if and when political theft happen and when politicians use SOEs as a means to solve unemployment problems through ‘sponsored employment’. Further, auditing of financial statements would have to be done without delays and more accountability will be created for these entities.

d.) Employees of SOEs will also benefit generously from Employee Share Option Scheme (ESOP) that can be offered to get the employee buy-in and commitment for better performance of SOEs.

e.) Well-run state-owned enterprises (SOEs) will be able to borrow funds through the issuance of securities in the capital market thus reducing their reliance on the Government for financing needs. Listed SOEs will then be able to raise more funds by way of both additional equity and debt offerings to the public and further reduce the budgetary burden of the Government.

Pension reforms

Government should consider pension reforms as vital to the development of the country. The long-term growth of capital markets of Sri Lanka will critically depend on demand side reforms in order to generate local demand for securities. When investment funds are allocated by the government political influence replaces returns as the basis for allocating the funds. As a result, investment projects that reduce national wealth rather than enhance becomes the reality as Sri Lanka has amply demonstrated by political boondoggles and high visibility projects favoured by politicians. Pension reforms play a critical role in channelling retirement savings into long-term wealth-creating projects, where the entire economy will significantly benefit with increase capital productivity and higher income in the long term. 

In Sri Lanka, the two mandatory and state-managed superannuation funds dominate the pensions industry. For example, the Employees’ Provident Fund (EPF) investment portfolio consisted 91.3% government securities, 4.2% stocks, 2.1% corporate debentures and the remaining 2.4% in fixed deposits as at end 2017. The problem with EPF is that it has provided a low return i.e. an average of 11.5% per annum for the period 1980 to 2017 to members. When compared with the average Treasury bill yield, which is the short-term risk-free benchmark and the average annual inflation per annum of 10.4% for the same period, the real rate of return from EPF of 1.1% (11.5% less 10.4%) over the period, is quite small.  Therefore, the monthly saving of 23% of the salary over the working life of the contributors will not grow to an adequate sum where the final withdrawal amount would be enough for a comfortable retirement. The returns paid to contributors is also low compared to the risk of investment portfolios. The funds did not pay a risk premium to contributors beyond the short-term risk-free rate although the portfolios of investments consisted of assets such as Treasury bonds, corporate bonds and equities that are long term and are more risky than short-term Treasury bills. Therefore, it is important to consider creating more broadly diversified portfolios subject to the investment constraints to optimise the risk-reward structure of these portfolios.

The private sector provident fund schemes with one-size fits all approach, do not provide investment options with different risk-reward structures to their subscribers. All investment decisions are taken by the funds. The lack of choice inhibits the creation of portfolios with varying degrees of asset allocation across different asset classes to suit subscriber preferences.

A key aspect of pension reforms should involve offering portfolio choices to subscribers and creation of investment portfolios based on subscriber choices. Alternative risk-reward structures that match investment risk and return preferences of contributors will contribute to more activity in the secondary market as well. Subscribers can be offered three portfolio choices such as a Gilt Fund (Treasury bills and bonds), a Corporate Debt Fund (Corporate Bonds) and a Growth Fund (equity) whose returns are benchmarked against indexes. 

The subscribers will have the choice to decide what percentage of their monthly contribution goes into which fund rather than mandated by the Government. This approach will also yield greater long-term benefits as the subscribers will become more educated about investment choices over time, contributing to the development of a more knowledgeable and educated investor base.

Considering the excesses both in equity and bond investments that have transpired it is imperative that the management of provident funds in Sri Lanka are free from political interference and investments made by the funds are fully transparent to the contributors. The funds should be managed by professionals with skill, competence and diligence and are committed to their fiduciary duty and place contributors interest before their own. They should be well paid and be supervised by an independent oversight committee to ensure proper procedures and policies are followed when making investments to prevent them being enticed by bribes and corrupt practices resorted to by unscrupulous companies to amass large profits as was done in the past.

It is therefore imperative that the Government strengthen the technical capacity, knowledge and competency of in-house fund management of the statutory contractual savings institutions. The capacity building needs may involve establishing investment policy frameworks and policies, portfolio management expertise, risk management and infrastructure and ICT systems for fund management operations. 

Digital transactions with Digital ID

A well-developed and competitive capital market with financial inclusion is a must, if Sri Lanka is to emerge as a strong knowledge based economy. Sri Lanka’s mobile penetration has reached 130% while data connectivity has reached 50%. Mobility has had a big role to play in the fintech revolution. The penetration of smartphones will provide unserved or under-served consumers a way to interact with financial institutions and gain real-time views into their unit trusts/stock trading. Inevitably, as mobile apps grow in sophistication, so will customer demand for intuitive unit trust fund investing and online trading.

Currently, Sri Lanka has only about 23,000 active investors (defined as at least four transactions per year) which is 0.1% of the population investing in the stock market. To enable financial inclusion, it is essential to expedite the completion of the e-NIC project commenced in 2011. However, the participation of the Sri Lanka’s citizenry in the digital economy remain extremely low compared to regional peers. For example, the transformation Indian equity market in the post 1990s to a world-class equity market is attributed mainly to the initiatives by the government of India to increase the retail investor participation with inclusive financing objectives. 

However, much is yet to be achieved with only 4% of the total population investing in the equity market in India compared to markets such as USA (48%), Singapore (20%), China (18%) and Malaysia (16%).

An irrefutable digital ID that is forge proof with biometric data is an essential ingredient of a digital economy. Use of biometrics such as vocal patterns, irises, thumbprints, facial recognition, will add an extra layer of authentication for transactions. The Government should bring in policies and regulations making electronic transactions more widespread while encouraging every citizen of the country to enter the digitalised era. One of the key challenges faced in opening any financial account in Sri Lanka is the physical visit required to the financial institution to open an account in order to carry out the ‘Know Your Customer (KYC)’ Anti-Money Laundering (AML) compliance.

At least for low value, i.e. up to Rs. 50,000, digital transactions the Department for Registration of Persons should facilitate financial institutions for real-time verification of NIC information such as the name and residential address seamlessly given the NIC number until the e-NIC project is completed. 

Conclusion

Unless the Government implements key reforms such as public enterprise reforms, pension reforms and e-NIC Sri Lanka will have a sub-optimal capital market, like a half-baked cake that nobody can eat. As the history has shown many a time, whether the current or future Government will have the political will and insight to carry out the essential reforms required to make the country prosper remains a question.

[The writer is the immediate past President of the Colombo Stock Brokers Association, President of the Association of Alternative Financial Institutions, and a former commission member of the Securities and Exchange Commission of Sri Lanka and was also the former President of CFA Sri Lanka, President of ITESA and Vice President of SLASSCOM. The views expressed in the article are solely of the writer and do not constitute an opinion of any company or any association the writer represents.]

(This article was originally published on OPA Journal Volume 34 No. 02 of September 2018.)