Sri Lanka’s potential to become a regional exchange

5 September 2014 05:45 am Views - 2736

Sri Lanka’s neutrality in the politically divided South Asian (SA) region and impending reforms in the coutry’s financial sector will unleash Sri Lanka’s potential to become a regional exchange trading regional dollar-based products for other countries in the region, according to an emerging market investment advisor.
According to emerging market investment advisor in international banks in Dubai, Hong Kong, Singapore and London, Michael Preiss, this neutrality coupled with the country’s highly educated talent pool will provide a competitive advantage for Sri Lanka to become a regional player in capital markets as done in Singapore and Dubai.
“So, a sophisticated stock exchange with several reforms in the pipeline most probably will unleash this process,” he said.

Further, the existing presence of several international banks and rating agencies will also enable the required infrastructure surrounding this development, further facilitating the transformation.

Preiss further went on to suggest the regulator to re-name the Colombo Stock Exchange (CSE) as ‘Colombo Securities Exchange’ because he believes the “stock exchange is a bit outdated” and it makes a much wider process looks narrower.   
“Look at what Singapore has done. Singapore is now the trading place for Malaysian, Thai, Indonesian and other countries’ products, and even Japan. A lot of Japanese Nikkei futures of the Tokyo stock exchange increasingly get traded on Singapore,” Preiss noted.
SA is historically being a hugely divided region where member countries, India, Pakistan and Bangladesh in particular are politically divided and therefore this situation invariably benefits Sri Lanka to trade products of every country in the CSE.  

Meanwhile, the experienced fund manager and the Ceylon Asset Management Company Limited (CAM) Managing Director Dulindra Fernando said, exchange and capital market liberalization plays a critical role in grabbing the top regional spot.
“SA is still very restricted. Capital markets are restricted. So, if we liberalize fast (like Singapore and Dubai did), we can capture this huge region,” he said.
According to Fernando who architectured the first dollar-denominated bond fund in Sri Lanka, this regional advantage will enable the country to introduce products such as India debt fund, Pakistan fund, SA fund etc. and to get them listed and traded on the CSE.
“No one has it and no one has done it before,” he added.

In recent times, Sri Lanka’s Central Bank (CB) has been relaxing exchange controls, and the budget 2013 allowed direct investments in foreign currencies in unit trusts without having to channel through Securities Investment Account (SIA) which came as a huge incentive to popularize investments in Sri Lankan securities by foreigners.
“So the secret is the dollar structures, good regulatory framework and doing regional products,” Fernando explained the recipe of becoming the regional financial hub.
All this will have the potential to turn the CSE from a rupee exchange to a dollar exchange.

Lacking infrastructure

However this requires infrastructure such as a clearing house or a credit guarantee corporation that minimizes counter party (parties to the transaction) risk in a securities transaction which is still lacking in the CSE.
At present, CSE share transactions are taking place with a huge counter party risk with no intermediary guaranteeing the settlement.
“They (foreign investors) won’t even believe there is no credit guarantee corporation in Sri Lanka. This is so unbelievable. In India and every single stock exchange to be taken seriously, they’ve got to have a credit guarantee corporation which guarantees to pay you,” Fernando said.  
Credit guarantee corporation will ensure the seller (of a stock or a bond) cash in his bank account in T+3.
“That risk cannot exist in a capital market. But in Sri Lanka that risk still exists,” he added.

Need for dollar board

Further, regional exchange status also demands a separate board in the stock exchange to list dollar bonds.
Currently Sri Lankan issued dollar bonds— sovereign, bank and corporate bonds— are listed on the Singapore Exchange (SGX). At present US $ 7 billion Sri Lankan bonds are listed in SGX.
“When we have a dollar board in CSE, we don’t have to go to Singapore. We buy the dollar bonds here. And all the dollars will stay inside the Sri Lankan banking system, “Fernando said.
However the capital market regulator, Securities and Exchange Commission (SEC) Chairman Dr.Nalaka Godahewa last week told Mirror Business they still don’t have plans to start a dollar board and discussions to that effect have not even thought of.  
According to Fernando, SEC will have to establish a clearing house prior to introducing a dollar board.

Step in the right direction

Nevertheless SEC  has given the nod to the country’s first dollar denominated unit trust, Ceylon Dollar Bond Fund (CDBF) in July this year that will open up investments in Sri Lanka issued dollar bonds by foreigners and Board of Investment (BoI) companies.
CDBF will exclusively invest in dollar denominated Sri Lankan sovereign bonds, bank and corporate issued dollar bonds, hence the risk exposure of this fund does not step out from sovereign and bank risk.

Currently there are six sovereign bonds worth US $ 4.5 billion in issue and US $ 1.85 billion worth bank issues and US $ 175 million worth corporate bond issues (SriLankan Airlines) listed on SGX.
CDBF received ‘BB-‘fund credit rating from Fitch Ratings in line with Sri Lankan sovereign ratings.
Last week, the fund received its first institutional investment from Melfort Green Teas (Pvt) Limited, and Fernando is taking the fund to New York this week to get more subscriptions from United States (US) pension funds.

“Our challenge is to get to a scale before we talk to them (US pension funds),” Fernando said.
He said CDBF should have at least US $ 25 million to qualify for such investors.
Nevertheless by now two US pension funds have already expressed interest in investing in the fund.
However Fernando expressed his confidence in building the fund base to US $ 100 million in a year’s time.

“Thereafter getting to US $ 500 million will happen much faster and after that there will be 10 other companies issuing dollar funds and they will all get US $ 100 million dollars each much easily, building the Assets Under Management (AUM) up to US $ 1 billion and it will go up to US $ 2 billion in another month,” he added.
However it is critically important to build the fund base locally before accessing larger US pension funds because such pension funds have maximum exposure limits. “So, they may not want to invest in more than 10 percent of the total fund as they also have exposure limits,” Fernando noted.  

CDBF received approval from both Central Bank and the Finance Ministry. Deutsche Bank acts as the trustee and the custodian banks while CAM manages the fund.
CDBF is similar to local unit trust funds but the only difference is that unit price is in dollars instead of rupees.
A dollar unit is priced at US $ 1 but the minimum investment is US $ 1,000.
CAM currently manages the Ceylon Income Fund which is rated ‘A-‘ the Ceylon Guilt Edged Fund rated ‘AAA’ by Fitch Ratings and three equity index funds; Ceylon Index Fund, Ceylon Tourism Fund and Ceylon Financial Sector Fund.

Eligible investors

The investment in the fund is currently restricted to foreign citizens—Sri Lankan diaspora with foreign citizenship, companies registered outside Sri Lanka, foreign fund managers and BoI companies.
But the company is seeking regulatory approval to extend the eligibility for Sri Lankans living abroad to also invest in the CDBF as the there were considerable amount of inquiries from them since the fund was launched.
“We have had about 60 inquiries so far from investors and most of them from Sri Lankans working abroad.
We have written to the SEC and awaiting approval to expand the scope of investors. The CB has already given their nod to go after any Sri Lankan working abroad,” Fernando said.

Meanwhile, CAM has also received commitments from two BoI companies, Further, few Sri Lankan banks too have expressed interest in investing in the CDBF.
“But we have to get permission from the CB and Ministry of Finance before taking their money,” he said.
Currently local banks are only allowed to invest in the sovereign and development bonds.
However, the banks could yield a higher return by investing in CDBF as the fund invests in a portfolio consisting of corporate bonds.
CDBF is expected to yield a dollar return in excess of 4 percent per annum.

Why high interest for Sri Lankan bonds?

“Sri Lanka has a fantastic story to tell. High GDP growth, inflation is coming down, trade deficit reduced by 47.9 percent from last May to this May. This is unbelievable. Foreigners look at the currency and they look at the trade deficit (before investing),” said Fernando, adding that these strong fundamentals attract foreign investors to Sri Lanka.  

Meanwhile, Preiss who is also a director of CAM said, US investors prefer to invest in Sri Lankan bonds as they offer a good diversification of their investment portfolio.
“And Sri Lankan dollar bonds are further attractive as the US interest is still very low,” he added.
It was only last week the International Monetary Fund (IMF) said Sri Lanka was one of the fastest growing countries, not only in the region but also in the world.
IMF’s annual macro-economic outlook on Sri Lanka which was just concluded (but yet to be released) projects the Asian emerging markets to grow at 6.4 percent in 2014 higher than the global economy which is projected to grow around 4 percent, advanced economies around 2 percent and emerging economies around 5 percent.  
During the first quarter, Sri Lankan economy grew by 7.6 percent and the full year target for 2014 is 7.8 percent.
Another reason for investment dollar bonds issued by Sri Lanka is the natural hedge against any foreign currency fluctuations because the investments are made in dollar units.

“Foreign investor is reluctant to get into rupee units because they are uncertain as to where the rupee would be when they want to exit,” Fernando said.
However, it was only recently the CB governor Ajith Nivard Cabraal said the rupee would be fairly stable with the potential to appreciate.
According to the IMF Resident Representative for Sri Lanka and Maldives Dr. Eteri Kvintradze the IMF has seen capital flows moving into emerging markets but risks remain due to potential rise in US interest rates.

“The faster than expected monetary normalization process in US could cause tightening of financial conditions and of course may cause global volatility,” she said.
However, countering it Preiss said that those that are flowing into dollar bond funds are not the speculative money but the real savings of the West.
He further said that investors prefer to invest in Vietnam’s bonds to Japanese bonds because Vietnam has a lot of economic potential with its younger population compared to Japan where the economy is slowing down with an ageing population.
Similarly Sri Lanka offers a higher economic growth potential and thus preferred by the investors.
“But the only issue with Sri Lanka is that Sri Lankan bonds lack liquidity,” he remarked.

That virtuous cycle

Sri Lankan issuers increasingly accessing the larger dollar space to raise capital and the subsequent secondary market activity created through dollar bond funds such as CDBF will trigger the start of virtuous cycle in the financial sector benefiting all stakeholders, according to Preiss.
In the very large dollar bond space, still the Sri Lankan securities either remain underweight (possibility of security underperforming compared to other securities in the portfolio from the analyst’s eyes) or the investors lack much exposure to them.

Hence, increasing number of dollar products will create visibility for Sri Lanka in the international capital markets and thus will gain recognition and reputation for the issuers.
“This improves the liquidity and the yield curve for Sri Lankan bonds on the SGX,” he added.
Usually, fund managers put pressure on the bond prices through continuous buying and selling of the bonds, creating liquidity in the secondary bond market for Sri Lankan bonds.

Currently investors are seen holding Sri Lankan bonds until they mature.  
“We as fund managers create liquidity in the secondary bond market. We put pressure on the price (bond price). And since we buy more than we sell, the price goes up and therefore the yield comes down,” Fernando explained.  

There is an inverse relationship between bond prices and its yield in bond markets.   
This leads to the next issuer the ability to raise funds at a lesser yield.
Continuous accessing of international markets will improve the credit ratings. Apart from that the benefits will feed through to all the stakeholders by way of fee incomes, uplifting the entire financial sector.

“And of course it will help the industry growth. So there will be income for the management companies, trustees, auditors, legal professional and the rating agencies as well,” Preiss said, describing the virtuous cycle created through accessing the dollar space.

Capital market and economic development

“The US is the most developed economy because they have the deepest capital market,” Preiss averred.
In the US, an average American who works for McDonald’s or Walmart has investments in the capital market.  “But here we don’t,” Preiss said.
Funds such as CDBF open up the dollar investment space for the small retail investor due to its similar qualities to a unit trust.
“So when the market goes up by 300 percent, the bus driver, the school teacher benefit from it. So over time when the economy grows, they too grow with it.
“But here in Sri Lanka the people still think the capital market is a club for rich people and opportunity for them to participate is still very less as it was expensive,” Preiss said.

Meanwhile, Fernando cited Singapore’s financial sector as an example which has now grown in to have Assets Under Management worth US $ 1.3 trillion (more than 10 times the economy).
 “At the beginning of the capital market development, Singaporean firms didn’t want to issue bonds for more capital because they had enough of low cost capital available from their banks.

But the Singapore government wanting to build a more dynamic capital market with regional presence said, ‘please you still do it because in that way you can create a bond market and then the so-called ‘yield curve,” Fernando explained.
The outcome is that when other companies want to issue dollar debt, they can issue at low yields to raise capital. This reduces their cost of capital and these low cost funds could be used to build factories, production and this way a country could develop the entire economy.
Singapore which started issuing Singapore dollar debt, now issues US dollar debt listed in SGX.  
            Pic By : Waruna Wanniarachchi