SECTOR ASSESSMENT (SUMMARY): FINANCE (CAPITAL MARKET) 1. Sector Performance, Problems, and Opportunities 1

Transcription

1 Capital Market Development Program (RRP SRI 49365) Sector Road Map SECTOR ASSESSMENT (SUMMARY): FINANCE (CAPITAL MARKET) 1. Sector Performance, Problems, and Opportunities 1 1. Market development. From 2006 to 2015, capital market development in Sri Lanka received only limited public policy support from the government. This largely reflected the fact that strong ownership was lacking at high government levels. One result was weakened investor confidence. The market capitalization of the Colombo Stock Exchange (CSE) as a percentage of gross domestic product (GDP) was stagnant at about 30%. Furthermore, the country s financial markets are under stress, largely due to concerns about the strength of the national economy, especially the fiscal position. The CSE price index has dropped 9% between January 2016 and June The performance is worse than other emerging countries, including India, Indonesia Malaysia, and Thailand. In addition, an allegation of fraud has undermined trust and confidence in the primary dealer market. 2. Limited role of the capital market in resource mobilization. Sri Lanka s underdeveloped capital market has not been effective in channeling savings into private sector investment in the economy. This reduces the viable financing options for companies and other borrowers seeking to grow. Bank assets account for almost 60% of the country s overall financial assets, and the sector may not be in a strong enough prudential or credit position to offer the long-term financing essential for infrastructure development and capital investment. The corporate bond and equity markets are both in the nascent stage. The ratio of outstanding corporate bonds to GDP is only 2%, and the 30% stock market capitalization GDP ratio is also significantly lower than those of other middle-income countries in South Asia. Table 1: Capital Markets in South Asia in 2014 (Percent of Gross Domestic Product) Country Stock Market Government Bond Corporate Bond Sri Lanka Bangladesh <1 India Pakistan GDP = gross domestic product. Sources: Reserve Bank of India; Securities and Exchange Board of India; Ministry of Statistics and Programme Implementation of India; Bangladesh Bank; Central Bank of Sri Lanka; State Bank of Pakistan; Dhaka Stock Exchange; Colombo Stock Exchange. 3. Key issues in market facilitation, demand, and supply. The market does not perform effectively due to shortcomings in the existing legislation governing the Securities and Exchanges Commission (SEC), insufficient market infrastructure, limited regulatory and supervisory capacity at the SEC, and a governance structure at the CSE that is not fully oriented to market development. Demand for capital market instruments is weak due to a lack of a credible, risk-free yield curve and of a liquid secondary market, which is the result of distortions in the auctioning of government securities, and to low investment by the institutional investors in corporate securities. Supply is also weak because most state-owned enterprises (SOEs) are not listed, and exchange-traded derivatives and asset-backed securities do not exist. 4. Strengthening the Securities and Exchange Commission. The new SEC bill will be enacted to remove current barriers to the introduction of new products and mechanisms to 1 No social and environmental issues were identified during the due diligence.

2 2 develop and expand the capital market, including market makers and short-selling (para. 7), mutual funds (para. 14), and derivatives (para. 17). As the capital market grows and gets more sophisticated, the SEC s supervisory and market development capacity needs to be strengthened. The SEC s staff size needs to be increased and its salaries raised to the levels needed to recruit appropriately skilled new staff members from the private sector. 5. Demutualization of the Colombo Stock Exchange. The CSE is owned and dominated by brokers whose individual business interests take precedence over the proper governance of the exchange and overall market development. The SEC has proposed a demutualization process to transform the CSE into a commercial, more professionally run organization. The profit-oriented, demutualized exchange will promote the introduction of the new products and trading systems to be made permissible under the new SEC bill, and establish the necessary supporting market infrastructure. 6. Market infrastructure. The CSE owns its automated central depositary system for clearance, settlement, and deposits of listed securities. The central bank owns a clearing and settlement system for government securities. However, no central counter party (CCP) mechanism with the components of risk management, clearing and collateral management and valuation, which will enable the delivery-versus-payment system for all the securities to reduce settlement risks. The existing online market surveillance system was designed for stock exchanges, and the data that can be extracted from it cannot be used as evidence in court. A new system that serves for a regulatory entity needs to be procured and installed. 7. Weak intermediary industry. The market intermediary industry, with 36 brokers, is highly fragmented and undercapitalized. New risk-based capital rules for intermediaries and a subsequent implementation of a recapitalization plan are essential to restore market confidence in the industry and provide a foundation for brokers to conduct market making and short selling (para. 9). The existing training and certification framework is outdated and was designed mainly for stock brokers. A new training and certification framework is needed to accommodate new financial products and strengthen the financial literacy of retail investors through education. 8. Strengthening auditing regulator. The Sri Lanka Accounting and Auditing Standards Monitoring Board (SLAASMB) is mandated to review all of the financial statements of more than 1,000 companies but has a professional staff of only 14. To make the SLAASMB a more efficient and effective regulator, its financial and operational independence needs to be enhanced through an amendment to the 1995 act that governs it. This amendment should allow SLAASMB to expand its financing sources, determine its own staffing needs and pay salaries, conduct risk-based review of companies, recover the costs of investigation and prosecution, and conduct qualitative reviews of audit firms. 9. Small equity market. Sri Lanka s small equity market provides less liquidity than those in other South Asian countries. 2 One reason is the lack of mechanisms for market making and short selling. The continued listing of companies that are not compliant with CSE s listing requirements weakens investor confidence. The limited listing by SOEs is a constraint on the market s size and liquidity (para. 15). 10. Bond market. The small corporate bond market reflects a lack of liquidity in the secondary market for government bonds. This hinders the development of a credible 2 The market turnover ratio was only 9% in Sri Lanka in 2015, compared with 9% in Bangladesh and Pakistan and 37% in India.

3 3 government yield curve. The lack of a transparent government bond issuance framework and a price discovery mechanism in secondary market trading is the cause of this inefficiency. 11. Issues in the primary market of government bonds. The current practices employed in the primary issuance of government securities are inefficient. They are characterized by (i) limited coordination between the Central Bank s debt management function and Ministry of Finance s fiscal operations, (ii) multiple series of bond issuances that limit the formation of large, liquid benchmark sries, and (iii) cancellation of bids in primary auctions to lower the government s borrowing costs. To smooth market expectations and create liquidity, these issues should be carefully planned and fully aligned with the government s fiscal operations as well as with market demand. Auction calendars should be published, and benchmark issuances increased. Auctions should be executed as announced. The market s primary dealers should have their capital bases increased to make the primary dealer system more resilient. In the secondary market, government securities are now mostly traded over the counter, and settlement prices are not published. An electric trading platform should be introduced to allow more transparency and predictability in the market and strengthen investor confidence. 12. Pension funds. The Employees Provident Fund is a state-managed defined contribution plan and the country s largest pension. Of its total investment portfolio of Rs1,604 billion (12.3% of total financial assets), 93% is allocated to government securities. Although the limited supply and lack of liquidity are obstacles to more investment in corporate securities, the fund should consider increasing the diversification of its portfolio to achieve higher risk-adjusted returns by including investments in foreign equities. Subscribers are deprived of the chance to have their savings allocated across different risk profiles in capital markets. 13. Insurance sector. The insurance industry is small, with a total assets GDP ratio of 4.2%. Market penetration was only 1.1% of GDP in On the positive side, industry investment portfolios are more diversified than that of the Employees Provident Fund (e.g., 41% in government securities, 20% in equity, and 14% corporate bonds). The industry needs to strengthen governance, strengthen the regulator, and provide more investor protection. To do this, the Insurance Board of Sri Lanka (IBSL) should strengthen its supervisory and market development capacity. The Insurance Act 2011 requires all composite insurance companies to be legally segregated between life and non-life operations and list their shares on the CSE. However, three companies have been allowed to operate without meeting this requirement. They include the Sri Lanka Insurance Corporation, which has a 36% market share. The IBSL also introduced risk-based capital rule for insurance companies since The IBSL must take steps to ensure that all the insurance companies comply with these regulatory requirements. The IBSL also needs to develop and execute a comprehensive strategy of retail education to strengthen financial literacy and raise awareness of insurance products. 14. Mutual funds at the early stage of development. The mutual fund sector accounts for less than 1% of total CSE market capitalization and lags behind those of other emerging countries. 3 The development of the mutual fund industry is hindered mainly by the absence of tax pass-through status and limited distribution channels. These issues should be addressed through a tax amendment and the introduction of universal brokerages. In addition, unit trusts should be promoted as a household savings tool through financial literacy programs (para. 7). 15. Insufficient equity and bond issues by state-owned enterprises. 55 state-owned business enterprises (SOBEs) generated total revenues equivalent to 12.3% of GDP in The Net Asset Value of Mutual Funds to the total market capitalization is around 10% in India.

4 4 However, most of them are not listed or issue debentures. They rely instead on government budget funds or bank loans. More equity and bond issues by SOBEs will provide liquidity in the secondary market. 16. Limited supply of alternative financial instruments. Alternative financial instruments need to be available to broaden and deepen Sri Lanka s capital market, but the country does not currently have securitization legislation in place to enable this to happen. Although quasisecuritization takes place, this provides neither bankruptcy-remote status nor capital relief for the issuing financial institution. 17. Absence of a derivatives market. Market participants have expressed a high level of interest in making use of derivatives for risk management. An efficient derivatives market requires a deep and liquid spot market for the derivatives underlying assets from which pricing information can be drawn. As a spot market develops, plain vanilla derivatives should be introduced under an enabling regulatory framework. The establishment of a CCP will provide the requisite platform (para. 6). The government also envisions the introduction of commodity exchanges and such commodity derivatives as tea futures. As an initial step, the demand for commodity derivatives and the market infrastructure requirements should be assessed. 2. Government s Sector Strategy 18. To achieve the GDP growth rate targets outlined by Sri Lanka s President in 2015 and in the government s 2015 budget speech, 4 the government aims to strengthen macroeconomic management, deepen policy and regulatory reform, and improve the incentive structure for encouraging private investment. In addition to an IMF program to strengthen the overall economy and a World Bank program to strengthen investment climate in the country, the government plans policy reforms to increase the incentives for private investment. These include the provision of long-term financing options by developing the country s capital market. To facilitate, 5 the government has prepared a capital market strategy as a first tranche policy action. 3. ADB Sector Experience and Assistance Program 19. ADB s financial sector strategy is included in its current interim country partnership strategy 6 and country operations business plan for Sri Lanka. 7 The sector strategy is based on the government s emphasis on private sector development, lessons from ADB s previous financial sector interventions, 8 and coordination with other development partners. 9 ADB support for capital market development is also in line with priorities of the midterm review of ADB s Strategy Sirisena Manifesto, New Democratic Front, A Stable Country, Maithri, Compassionate (The President Sirisena s election manifesto). Colombo; Ministry of Finance Statement by the Minister of Finance on Hundred Day Revolution (The revised budget speech). Colombo. 5 SEC Capital Market Master Plan. Colombo; SEC Capital Market Development Roadmap. Colombo. 6 ADB Interim Country Partnership Strategy: Sri Lanka, Manila. 7 ADB Country Operations Business Plan: Sri Lanka, Manila. 8 ADB provided a $65 million program loan to Sri Lanka in 2004 for (i) increasing the financial products and services available to capital markets, (ii) enhancing corporate governance in the financial markets, and (iii) improving the regulations for the insurance industry. ADB Completion Report of Sri Lanka Financial Markets Program for Private Sector Development. Manila. 9 Development Coordination (accessible from the list of linked documents in Appendix 2). 10 ADB Midterm Review of Strategy 2020: Meeting the Challenges of a Transforming Asia and Pacific. Manila.

5 5 I. Problem Tree for Capital Market Development Stifled economic growth and poverty reduction in Sri Lanka Persistent infrastructure investment gap Limited foreign direct investment Ineffective mobilization of savings in the economy Limited capacity, size, and development of capital market Limited demand for securities Ineffective market facilitation Limited supply of securities Limited government bond market development Limited participation by institutional investors (pension, insurance sectors) Lack of effective legal and regulatory frameworks and market infrastructure Limited supply of corporate bonds and equities Absence of derivatives and alternative asset class

6 6 Sector Results Framework (Capital Market Development) Outcomes with ADB Contribution Country Sector Outcomes Country Sector Outputs ADB Sector Operations Indicators with Targets and Baselines Outputs with ADB Contribution Indicators with Incremental Targets Planned and Ongoing ADB Interventions Main Outputs Expected from ADB Interventions Size, depth, and capacity of the capital market enhanced Stock market capitalization as % of GDP increases to 25% by December 2018 (March 2016 Baseline: 23%) Total value of annual corporate bonds issuance increases to SLRs75.5 billion by 2018 ( baseline: annual average of SLRs68.6 billion) Total investment portfolio of EPF, ETF and insurance companies in nongovernment securities increases to SLRs302.9 billion by December 2018 (2015 baseline: SLRs275.1 billion) Effective market facilitated Demand for securities enhanced Supply of securities enhanced A new SEC bill, a demutualization bill, and SLAASMB bill enacted; and market infrastructure, including CCP mechanism, established Reliable benchmarks established for government bond market Participation of institutional investors in capital market increased Equity issuance increased Legal and regulatory framework established for derivatives and assetbacked securities Planned target subsectors N/A (The proposed program covers all the subsectors) Pipeline projects with estimated amounts N/A Ongoing projects with approved amounts CDTA: Mobilizing Finance for Sri Lanka ($0.5 million) Planned target subsectors N/A (The proposed program covers all the subsectors) Pipeline projects N/A Ongoing projects Ability of plantation companies and SMEs to access private investment from capital markets strengthened CCP = central counter party, CDTA = capacity development technical assistance, EPF = Employees Provident Fund, ETF = Employees Trust Fund, SEC = Securities and Exchange of Sri Lanka, SLAASMB = Sri Lanka Accounting and Auditing Standards Monitoring Board, SLRs = Sri Lankan Rupees, SME = small and medium sized enterprise Source: Asian Development Bank.