Cultivating the capital market

By Charumini de Silva

Capital Market Conference 2017 came alive with straight talk and futuristic observations on the Sri Lankan economy, with the need for consistent policies and prompt execution intertwining through the discussions. 

Organised for the fifth consecutive year by UTO EduConsult; the conference saw plenary sessions on ‘State of the economy’, ‘Impact of the Budget on Capital Markets’ and ‘Equity markets’.

Delivering the opening remarks Calamander Capital Singapore Director MafazIshaq pointed out that the looming issue of our debt, pressure on interest and exchange rates, impact of VAT hike and the slowdown exports would all have an impact on the economy, but the greatest challenges would be from external factors where the impacts would be felt far and wide.

Stating that the inadequacy of the country’s capital market should be understood historically, he said: “Our capital market needs scale and depth in order to function, but Sri Lanka’s legacy of political journey and geographic fragmentation prevented that formation and as a result we are much poorer now because we have lacked the ability to be accumulating our own wealth.” 

He emphasised the importance of regional and continental integration in the current global economic context, however admitted that markets only work when participants believe it is fair and transparent.

“In this regard, the quality of corporate governance in region must be raised for Sri Lankan companies would be able to grow into cooperation with continental and global reach,” he added.

He also highlighted that capital market depended on integration of technology and trust, where it is going to be a part of the infrastructure optimism, upon which Sri Lanka’s prosperity rises.

In addition Ishaq called on the stakeholders to make their submissions to the Securities and Exchange Commission Act 2017, which is currently in draft format.

Get the politics right to drive the economy

The first discussion on ‘State of the economy’ was moderated by Daily FT Editor Nisthar Cassim and comprised top corporate leaders including KPMG Managing Partner ReyazMihular, Sarvodaya Development Finance Chairman Channa de Silva, Economist Deshal de Mel, Frontier Research Lead Economist and Senior Product Head Shiran Fernando and Capital Alliance CEO Gihan Hemachandra, where they called on the Government to get the politics right to drive the economy.

Mihular said it was crucial to translate the vision set out by the Prime Minister Ranil Wickremesinghe which was highly endorsed as the way forward for Sri Lanka without holding back due to unreasonable political motives.“We just have to bite the bullet and get these things implemented,” he added.

Noting that foreign investors still had an appetite for investment opportunities in Sri Lanka, he pointed that there was a willingness to pay taxes, but policy consistency was a concern for them.

Considering the current global economic outlook, Mihular pointed out that there would be no significant investments the country could expect from Western economies. Therefore he said in this context China would be the only powerhouse that would invest in Sri Lanka.

“China has come up with a proposition that if we execute, they will make the entire south a very vibrant export zone making a lot of use of the Hambantota Port. It is not only debt issue, but the vibrancy that comes in with the industrial zone, export income generation and the use of Mattala Airport,” he noted.

He cautioned that if the authorities do not resolve the legal issues related to the project any soon, the investors would walk away.

“We have got a coalition Government and both parties need to get real. I think they are all paying games and eventually the country suffers. They need to get the economy out of this mess, if not the Sri Lanka will end up like Greece,” Mihular warned.

De Silva said that the authorities had failed to stabilise the rupee which is the single parameter that explained the health and wellbeing of an economy.

“Now the prime lending rate is 11.5%. SMEs are borrowing at 18% to 25% and sometimes it’s more. Micro finances are borrowing north of 30%. Some people are charging 40% and some 50% effective rates — but still keep on borrowing,” he stressed.

He explained that currently the strength between inflation and prime lending rate in Sri Lanka is at least 600 basis points, whereas in Japan it is only 60 basis points, cautioning that the country was burdening local entrepreneurs with high borrowing rates.

“My only fear is the role Sri Lankan entrepreneur will play against the large Chinese, India, European tickets (projects) that are expected to coming in. What is the role of the Sri Lankan entrepreneur who sacrificed his life living in this country to serve this country? If you are going to bleed them out charging them 25% to 30% debt they take, what is the peace dividend that the Government is going to reward them with?” he questioned.

Despite the very powerful private sector engine that is very optimistic in Sri Lanka’s future, the tumbling Government sector had created disappointment in delivery expectations to a certain degree, he said.

Commenting on the economic outlook for this year de Silva said that owing to the small economic base, the country would start to grow at a very low level.

Stability at a cost

De Mel commended the economic reforms which took place in the first half of 2016, where the country managed to escape a very tricky situation, noting that there was better economic stability today from a macroeconomic perspective.

However he said out that this stability came at the cost of high taxes, high interest rates and a weaker rupee. Therefore he said that these factors would result in weaker consumption as well as moderate earnings from businesses to a certain extent in the next two years.

Explaining that there were no major inflows of income to meet the magnitude of repayments Sri Lanka have to make in 2019 and beyond, de Mel insisted that the consolidation needed to continue for the next two years at least.

“We are in a lucky situation as we don’t have any significant external debt repayments coming up for the next two years. Come 2019 and beyond there are very large external debt repayments. Therefore we have to make sure by that time we have the correct macroeconomic stability to have the confidence of global markets to be able to continue to refinance that debt,” he added.

On the bright side he said the economy would see interest rates take a downward trend from the second half of this year.

De Mel also acknowledged that the challenges in the political front would also manifest in macroeconomic sentiments, adding that it was crucial for the Government to have the capital to overcome any negative impacts.

Fernando emphasised that this year the country would probably have to recalculate its expectations and push policymakers to get the low-lying fruits required for the private sector to kick off growth.

“Although a lot of fundamentals have improved and are improving such as the IMF reforms, more independent Central Bank and even Fitch ratings have not been taken as positive by the corporates, investors and markets because everyone is still in that negative sentiment framework. This needs to change,” he added.

Noting that in general the expectations and sentiments were quite depressed during the past two years, he called on policymakers to be strategy sensitive as well.

Given the current external sentiments he asserted there was room for improvement in general from an overall economic perspective, but admitted that the fundamentals were moving in the right direction.

“For a year we would have to endure a stabilised economy with low consumption and moderate earnings,” Fernando added.

Hemachandra said the current economic situation was similar to a storm before the calm and being a frontier Sri Lanka needed to expect the volatility.

Nevertheless he asserted that the results of fiscal consolidation and stability shown in Western economies would have a favourable impact towards the economy in the later part of this year.

CGT, white elephant in Inland Revenue Act

The second session on ‘Impact of the Budget on Capital Markets’ included panellists such as First Capital Holdings Plc CEO Dilshan Wirasekara, SEC Consultant P.Asokan, Candor Group Director Ravi Abeysuriya, KPMG Principal – Tax and Regulatory Suresh Perera and NDB Wealth Management Vice President – Asset Management Vindhya Jayasekera.

The Budget 2017 reintroduced a 10% Capital Gains Tax (CGT) on gains from the disposition of immovable assets, effective from 1 April. However, it was pointed out that if introduced, it would have a cascading effect on the already-deprived stock market and that the stakeholders were not anticipating a CGT on the share market.

“We do not expect CGT to be applicable to stocks, but if it is introduced, it would be a nightmare to implement or collect taxes owing to its complications,” Abeysuriya said.

He asserted that the implementation of CGT had always kept away investors from the stock market and it has been proven in so many countries.

“The Government will get less revenue if they implement CGT in the stock market,” Abeysuriya added.

Perera said the CGT would not be applied on shares of the stock market, but on immovable property at a flat rate.

“In Sri Lanka, up to 2002 there was tax on CGT at a multiple rate system depending on the holding period. But the CGT proposed by Budget 2017 would be will be flat rate of 10% for immovable property less than 10 years,” he added.

Noting that even when the CGT was there before 2002 it did not contribute significantly to the Inland Revenue Department, he pointed out that there was no legislation on CGT hitherto and thereby the reintroduction of CGT was a white elephant in the new Inland Revenue Act.

“We are all waiting with fingers crossed to see how CGT is going to be enacted,” he said noting that additional details were still expected including liable assets, exemptions and determination of the gain, among others.

Perera however said it was important to make a distinction between trading profit and capital gains using the concept of badges of trade such as nature of the subject matter being exchanged, the length of ownership, and the reason for the transaction, which are essential in accounting as non-trade transactions are taxed differently. He believes CGT would be mainly focused on capturing those who buy and sell lands and apartments often without getting caught to the tax net.

“If a person buys a land today and sells it in another two years, because the holding period is short, it will be trading profit and the existing Inland Revenue Act has the highest slab of 24% for that. It determines the intention of the buyer at the point of purchasing an asset, whether it was for long-term or short-term with the intention of making profit,” he explained.

Perera said people who would hold a property for eight years would now wait another two years to get the exemption, adding that those who sell their own residential property may not be liable for CGT.

He also stressed that reintroduction of CGT would have a locking effect on the economy and the Government would not earn significant revenue.

“The perception that Sri Lanka has CGT even for immovable property will have a negative effect on investments,” Perera noted.

Dilemma for unit trust industry

In terms of the unit trust industry, Asokan said the Government had been conceding tax concessions to promote the industry with the intention of broad-basing the share ownership. However, the removal of tax incentives may now result in a significant outflow of funds from the industry and exert pressure on the unit trust management companies.

On the other hand, he said this would persuade the unit trust management companies to focus on increasing their retail investor base and promote equity funds as these funds would continue to remain tax exempted in the hands of the investors.

However, Jayasekera said that it was difficult to promote unit trusts with 0.5% fund management fee, insisting that it was important to have large corporates to create more fundavailability in the industry.

“For grassroot level investors, fixed deposits and Government securities are the entire universe of their investment horizons.We are trying to compete with a Rs.100 billion fund against Rs.8.3 trillion banks’ asset base. Therefore we need larger funds available to the market in order to promoteunit trusts,” she pointed out.

The unit trust industry was assisted to collect funds from corporate investors who could enjoy a tax benefit of 18%, but in the 2017 Budget proposal such benefits to corporate investors have been removed.

Wirasekara pointed out that 80% of the total unit trust fund was held by large corporates and as a result of the Government’s budget proposal, they now find it difficult to manage the cost involved in managing funds, with a lot of companies now considering winding down some of the funds.

“It is a chicken and egg situation now. The cost involved in fund management in the unit trust industry is huge at present. We are also thinking of moving out,” he quipped.

According to him the Rs.130 billion unit trust fund in 2015 dropped sharply to below Rs.100 billion last year and with the implementation of the Budget proposal from 1 April the fund would see a deeper plunge, noting the impact on the industry was huge.

Overall, Abeysuriya pointed out that there is a huge gap in understanding the capital market among most of the stakeholders where decisions are made without studying the impacts, resulting in unfortunate situations.

“Ultimately, we are in chaos as investors leave the market,” he added.

Market in a limbo 

The third session on ‘Equity markets’ comprised panellists such as StaxInc Director Dr.KumuduGunasekera, Softlogic Holdings Head of Investment Niloo Jayatilake, CSE CEO Rajeeva Bandaranaike, Acuity Partners Managing Director Ray Abeywardena, KPMG Principal ShilukaGoonewardene and SEC External Relations and Surveillance Director ThusharaJayaratne.

Commenting on why the market has not reflected the growth of the economy, Bandaranaike emphasised that a push was needed for investment within the country itself for companies to reach out to the capital market.

“The country needs to have an economic boon for this as only then they will realise that the internal funds are not adequate for their growth — that is the time they will reach out to the capital market and that is the time you will really see the capital market surging.The future potential is a huge with many companies in both State and private sectors waiting for the right time to enter the market.”

Despite the fact that the market is in a limbo due to a combination of factors, he said that it represented a good buying opportunity for investors currently, insisting they should make use of the opportunity.

“In terms of the market today, there are no investors in the market. The State institutions need to come in again and give a lead. We are not the only girl on the beach; there are other attractive stocks in different markets for foreign investors to look at. We have been offering the same kind of stocks for years and 90% of the market is really not active, it is a cascading effect. I think we need to collectively work to short-term action to get the market activated. We cannot wait for the Government to come and bail us out. We are trying out different strategies to bring life to the market with different products and boards,” he noted.

Endorsing the CSE Chief’s comments, Jayatilake pointed out it was natural to have cycles in markets, but stated that the very negative, doom-and-gloom mindset of investors all the time was uncalled for.

“I am sad to see institutional investors waiting for the best of times to invest, whereas they are the ones who have the holding power to buy at the worst of times. I can understand the psyche of a retailinvestor, because they don’t have the holding power. There is no divergence between institutional investors and retail investors in their thinking right now. In Sri Lanka, it is mostly like following the herd. Sohow do you create wealth for your unit holders, for your clients?” she stressed.

Noting that the stock market was highly politicised during the last election and got a really bad name,Abeywardena pointed out that lack of confidence was one of the key factors for whatthe market is experiencing today.

“During election time stock market became a hot topic with pump and dump, sudu-pola and we still see the negative connotations from that,” he added.

Although the country was hopeful from 2015 that things would change, Jayatilake said no significant transform was evident from the private sector.

“Everything the Government is talking about in terms of policy and structural changes, we still have not seen any sizeable investments on manufacturing or exports except in the hospitality sector,” she added.

Stating that sentiments drive markets to a great extent, she pointed out that due to the negative sentiments, many family-owned businesses do not want to list in Sri Lanka and were now looking at listing overseas, especially Singapore.

“We are losing another set of companies that would have come to CSE and now moving to other markets and go global. We are not capturing or trying to convince them. Sometimes, it is important for the regulators to amiably change to entice these companies to be listed in the CSE. I think the majority of economy is not represented in the CSE. The top foreign exchange earners of garment and tea are not listed. The huge divergence of sectors is not represented in the CSE,” she added.

Abeywardena said the fact that family businesses were looking at listing in Singapore was a direct threat to CSE, admitting that they also had a few companies in the pipeline to be listed, but because of the low valuations they were waiting.

IPO vs.private equity

Outlining that there are quite a number of firms waiting to be listed in the CSE, Bandaranaike said it was a matter of timing, however he added that the Government at policy level must also commit itself by way of listing SOEs to add size, variety of shares, volumes and liquidity into the market. 

“It is important to excite the investors. If you analyse the IPOs we have had, most of them are trading below the issued price — that’s a fact. But if you look elsewhere like Bangladesh, the IPOs trading valuesare well above issued price. These are issues we need to look at,” he pointed out.

Goonewardene also admitted that past IPOs were fundamentally over-valued and therefore thoseretail investor who burned their fingers still have those awful memories which is one of the reasons why there was no appetite for IPOs at present. However, he said on private equity it was slowly picking up as they were starting to invest.

He insisted that if a company wanted to raise funds or liquidity the market was still the best place and said the public needed to understand it.

Abeywardena said private equity is a precursor to an equity listing. “I think when companies don’t feel ready for a listing and the valuations they look for are not there, they would consider private equity as a step to stabilise and strengthen the company. Then they look at an exit through an IPO in a three to five year time horizon.”

Dr.Gunasekerahighlighted private equity as a definite threat to the CSE, adding that it allowed companies to go out of Sri Lanka. 

“There are a number of global funds that have been looking at Sri Lanka for the past four to five years, keen to open a dedicated fund for Sri Lanka. These are all global funds looking to enter the market; it is going to be a different ballgame. We need to ask why companies need to go for an IPO. What’s the benefit of going to an IPO? Valuation is an important factor here, because private equity fund managers are looking into maximising their investments, but the exits for those companies will also be higher. They come for a shorter duration of three to four years, they are driving the companies towards growth, but at the exit point the entrepreneur will have higher valuations,” he explained.

Take the bull by its horns

Abeywardena said the lustre of the market was fading away from a foreign and a local perspective, but one cannot say that it was only a regulatory issue or lack of confidence.

“The Government acknowledging the role of stock market is imperative at this juncture. We have seen statements on SOEs being listed, but there is no clarity. No one up-to-date has come out and said that there will be no Capital Gains Tax on the stock market. There is a lot of uncertainty.I think there is apathy when it comes to the CSE from the Government’s perspective.”

However he said that the regulatory framework could be more conducive to encourage companies to enter the market.

“Until a holistic, high power Governmental driven body takes the bull by its horns, the market will be in a limbo,” he added.

Although there is an impact from what took place in the market in 2010 and 2011, Jayaratne refused to accept that the market was overregulated. “We have to keep a balance of regulating market development.”

With regard to investigations, Jayatilake said it was unfair not to disclose the details of the investigations being conducted by the SEC, insisting that the information should be made available to the public.

In response Jayaratne said that SEC could not disclose details of ongoing investigations, but information about closed cases had been published on the SEC website.He further noted that 11 such closed cases had been reopened recently for further investigations.

Pix by Lasantha Kumara