What we need to do to ensure a strong capital market

Today, our capital market could do a lot more to rev up our economy like in some other markets in the region. Market capitalization to gross domestic product (GDP) currently is less than 25 percent. In 2010, it was around 39 percent. In Singapore it is over 250 percent and Malaysia 160 percent. As a goal we would like to see market capitalization at least around 50 percent of GDP in the next few years. Therefore, the question is what do we need to do to 

get there? Generally, capital markets channel funds from savers to firms, which use the funds to finance projects. Informational efficiency is necessary if funds, allocated through the capital market, are to flow to the highest-valued projects. Shareholders want management to maximize stock prices and thus, will attempt to ensure that their managements undertake only projects (decisions) that increase the value of their stock. 

Management compensation packages tied to stock performance are one way in which stockholders align management’s interests with their own. However, maximization of stock prices can result in the capital market directing funds to the most valuable projects only if stocks are efficiently priced, in the sense of accurately reflecting the fundamental value of all future cash flows. Thus, for example, if capital markets are efficient, there is no reason for executives to focus on the short run at the expense of long-term projects. 

Additionally, efficient capital markets make it easier for firms to raise capital because the markets determine the prices at which the existing and potential security holders are willing to exchange claims on a firm’s future cash flows. The role of the government in a developed or in a developing market involves developing, implementing and promoting a consistent set of regulation, providing oversight and enforcement in order to protect all investors, maintain fair, efficient and transparent markets and addressing any systemic risks that may exist in the market from time to time.

In order to achieve these, the regulator who is entrusted with the job, should have operational independence and accountability in the exercise of its powers and functions and observe the highest professional standards and demonstrate competence. The regulator on the other hand should not overstep the responsibility, instead allow the markets to evolve within the accepted parameters and support business to raise capital via the market.

 The ever increasing cost of compliance is often a big challenge for most small and medium enterprise (SME) businesses to grow and expand. The regulator would therefore need to continuously educate the SMEs about the benefits of listing and about the role of capital markets because compliance has a cost but the benefits of listing overweight those costs. It is actually lack of awareness of opportunities that prevent most companies coming to the market. Also rebuilding public confidence and reactivating mass-scale retail participation must be a priority for the regulator.
 

Expectation
The regulator should also continue to promote more liquidity for potential foreign investors to attract more foreign direct investment (FDI) into the country. The approach could be threefold.  
A) Maintain a minimum public float. This is expected to release more closely held stocks to the market and a strategy to promote more Initial Public Offerings (IPOs) into the market targeting a large number of successful but non-listed companies.

B) While they encourage more companies to list, they also need to support to build capacity in the boardroom to safeguard the interest of the public and the investor.

C) Motivate MNCs having entities in Sri Lanka to list by offering incentives and also encouraging PLCs to have robust dividend policies.

The regulator should also study the rules imposed by regional counterparts like Vietnam and Singapore related to new market initiatives, digital strategy, board room capacity and the listing rules to assess what initiatives are required in this area.Some of the areas that need focus are:

A)Strategies to strengthen the corporate debt market
B)Demutualization of the Colombo Stock Exchange
C)Incentives to get retail investors to the market.In addition:

1. Strengthening the broker back office system through harmonization amongst the brokering houses by using the latest technology.
2. Enhancing capital market education and improving financial literacy in the sector.
3. Introduction of a central counter party CCP system, which is critical to broad base the product portfolio.
4. Changes to the SEC act to further fine-tune the regulatory framework where major emphasis would be to provide civil and administrative enforcement powers.
5. Create a framework to boost the unit 
trust industry.
6. Facilitate derivatives and expand the bond products, introducing ETF, introducing REITS, etc.
7. Initiative to increase the number of listed companies in the market; currently around 290+.
8. A clear strategy to attract new investors both local and foreign to expand the capital markets by setting up of a private public capital market development council.
9. Consistency in policy implementation e.g. on land rights.
10. Building HR regulatory capacity. 
(Dinesh Weerakkody is a senior company director)