What’s wrong with the stock market?

As the enactment of a powerful new capital market law nears, we discuss what really ails Sri Lanka’s stock market

Trust, the glue that holds together capital markets, began to dissolve in 2009 as investors began to realise that the market was rigged against them. By mid-year 2011, the resulting price bubble had popped and stocks were in freefall. Six years since the bubble’s popping, the market is far from regaining the trust it lost so quickly.

For ordinary Sri Lankans, the stock market is something of an anachronism, accessible only to Colombo’s elite and one with no impact on their lives. This isn’t surprising because the most profound destiny-altering events are often the most banal. The scandal that rapidly spread beyond capital market players to include the most powerful people in the land failed to capture the public’s imagination due to the everydayness with which laws and regulations were set aside, so that nothing stood in the way of plunder.

Twenty years in the making, a new capital markets law in the form of a new SEC Act is expected to move from the consultative stage it is in now to soon become a law. In the form of a giant carrot is an ADB loan that will disburse half its $250 million value only when the new SEC Act is made law. Facing large budget deficits and foreign debt repayments, the government’s apparent haste to push the law though the legislature may be due to this dangling carrot.

A new SEC Act will do a great deal to regain trust, but to expect it to immediately spark a vibrant market turnaround may be to expect too much of it.

In the eight years since this crisis erupted, the stock market’s legitimacy as a fair, orderly and transparent place to trade securities has continued to erode. This is due to the waves of subsequent scandal that have dogged it. Early on, it was an erosion of the regulator’s ability to act independently in the face of blatant market manipulation, insider trading and challenge to its authority.

In the eight years since this crisis erupted, the stock market’s legitimacy as a fair, orderly and transparent place to trade securities has continued to erode

The stock index peaked at around 7,700 points in February 2011 when trailing price-to-earnings ratios topped 22 times. Six years later, by March 2017, the stock index is still 22%, lower than its all-time peak. S&P’s SL20 index of the most liquid stocks has halved from its peak also reached in 2011.

Clearly, the Sri Lankan stock market is no longer for the faint of heart. In four of the last six years to 2016, stock prices have declined following their record 125% and 96% gains in 2009 and 2010, respectively. In 2016, stock prices declined 9.7%. Those smarting from their losses nursed grievances against stockbrokers who herded unsuspecting investors into stocks where valuations defied conventional wisdom; rich investors who benefited from insider information or manipulated share prices, destroying trust in the system; and a regulator that decried the carnage without acting.

Resetting expectations at the end of an almost three-decade-long conflict, ending in 2009, was predictable. Certainly even a modest resetting would have been met with disappointment. Sri Lanka’s exports are stumbling, economic growth in the last couple of years is lower than it was during the war, and investment – an indicator of future growth – is anemic. Never entirely credible claims by the government that the economy is chugging along now elicit open derision from the private sector.

Eight years following the conflict’s end, the stock market drift illustrates the reality of Sri Lanka’s disappointing economic trajectory. It is a bitter irony to stakeholders, including businesses unable to secure attractive enough valuations to raise risk capital for growth. The market’s decline has been both absolute and relative. Absolute because the Colombo Stock Exchange’s main index is 22% off its peak and declined 5.5% and 9.7% in 2015 and 2016, respectively. It’s a relative decline also because market-wide earnings have been growing at rates between zero and 40% quarter on quarter. Stock prices not keeping up with underlying earnings growth is a re-rating of the market downwards.

Sri Lanka’s stocks are at a discount compared to regional markets. According to Bloomberg data, Sri Lanka’s stock market prices were trading at 12 times their earnings. In India, stocks were trading at 20 times, China 17.9 times, Malaysia 16.4 times and Pakistan 15.9 times in December 2016. Sri Lanka’s low earnings multiple makes it cheaper than these and other regional peers’, but it’s also indicative of a possible lower earnings growth expectation and higher risk. (See table: Lower valuation indicative higher risk?)

Echelon interviewed half a dozen capital market professionals and others whose views we figured offered insight into addressing the challenges faced by the market. Their take on what ails the market and the Asian Development Bank’s views published in three documents in the lead up to its lending $250 million significantly informed this story. The erosion of trust, now a well-documented episode in Sri Lanka’s capital market, is the first cause of the stock market’s drift since the bubble burst six years ago. The second reason is government apathy over the last decade to address any structural, governance or law and order issue as far as the stock market is concerned. A third reason for the drift is the absence of key market players, some spooked by the possibility that they will be prosecuted for past wrongdoings and institutional funds under state guardianship. Behaviour is driven by primal ambition, competitiveness and individual drive for power. Often, a framework of laws and regulations, ethical practices, and morals work in preventing the abusing of a system. When it becomes apparent that the leaders in charge have a wonky moral compass and are flip-flopping on values – those publicly preached and privately practiced – the message is transmitted to the rest of society and quickly becomes a part of the culture.

In capital markets, the casualty of that behaviour was trust. Stockbrokers were blamed for the degeneration of the market’s unethical practices. It’s reinforced by a stereotype of stockbrokers as personifications of greed. However, the rot has spread far wider to include investment bankers who hyped IPOs to multiples of the value private placements had been concluded at just months before, research analysts who didn’t warn investors of these questionable valuations, and investment bankers offering inducements to managers of state-managed funds to place lower-than-market yield papers without due diligence on an investment.

The SEC’s proposed new act – which received cabinet approval – brings within its preview investment banking – including unlisted banks – and Registered Investment Advisors (RIA), as junior stockbrokers are referred to in the industry. Previously, only the chief executive and directors of a brokerage could be held to account for a breech by an RIA.

Existing SEC acts have a number of weaknesses that went unaddressed as successive governments ignored its update as a legislative priority. This apathy may have been self-serving. Many political backers were also significant traders in the period when stock prices reached heady levels. Their influence was far reaching enough to control the legislative agenda.

Against tremendous odds, the SEC under Thilak Karunaratne (who was reappointed to the role in 2015) and his predecessor Indrani Sugathadasa fought assiduously against a corrupt ‘mafia’ because there was far more than personal honour at stake. The island’s securities regulator – many of its employees and commissioners – had realised they were the only thing standing between greedy robber barons, and their plundering of savings and future pension receipts of investors and office workers.

Karunaratne may yet get to conclude the investigations commenced during his first tenure when market price manipulation was rife.

An administrative sanction in the proposed law allows for ‘recovering of damages on behalf of investors’ within six years from the date on which the commission became aware of the contravention. To understand how, it must be appreciated how fundamentally different the bill is to the law that it proposes to replace. Provisions dealing with ‘market misconduct’ are replacing those in the current act that address the ‘protection of the interests of investors’. The changed tone is not limited to provisions related to how the commission’s responsibility is defined, but extend through the proposed bill.

A significant change is enhanced quasi-judicial power the SEC gains, extending the reach of the current provisions around compounding offences to deal with insider dealing cases. The commission can ‘take action’ against an ‘insider in public interest’ to recover up to three times the illegal profit gained or loss avoided by imposing a fine. Like in other jurisdictions, the SEC won’t require court sanction to impose a fine. An aggrieved party by such SEC action must go to courts to challenge the imposition of the fine. Significantly, all insider dealing cases provide for criminal as well as civil liability. Critics point out that the proposed law’s high subjectivity will lead to lengthy court battles to figure out how provisions must be interpreted. The market for capital is a key economic institution in any country. Unlike banks, which fund short-term needs of firms with good share flows, the capital market can arrange long-term funding, from investors with greater risk appetites to source funds from far corners of the world.

Higher demand for securities lowers the cost for companies raising long-term funding. The stock market is the most visible institution in a country’s capital market and offers the cheapest funding that also doesn’t have to be returned. Low-cost equity boosts firm productivity and global competitiveness, and lowers the cost of goods and services to consumers.

Naturally, investors are choosy and seek lower valuations to compensate for higher risks. Foreign investors queasy about risks here due to weak corporate governance, lax regulation and a system being gamed to exploit them have looked elsewhere in the past. Sri Lankan investors have often preferred ssets classes like fixed income and real estate to equity. The capital market has also not been successful in channeling savings to support private sector participation to reduce the large infrastructure deficit – a major constraint to higher and sustainable economic growth. Bank financing accounts for 60% of the country’s financial assets, but it is unable to finance infrastructure needs, as this would expose banks to risks such as maturity mismatches, observes the ADB’s concept paper on the loan and technical grant for the Capital Market Development Programme.

The technical study and other material related to the loan can be downloaded from the ADB website. However, they don’t include the loan agreement, which was signed between the ADB and the government in November 2016. A source with knowledge of the contents claims that half the loan, or $125 million – which the government can choose to spend on anything, as it’s a programme loan – is linked to having the SEC’s updated law being approved in parliament.

The concept paper states, “All first tranche policy actions are expected to be complied with by the time the programme loan is submitted for Board consideration in September 2016. The first tranche will be disbursed upon loan effectiveness.” The concept paper does not disclose what constitutes ‘first tranche policy actions’.

That the government will get cold feet about passing new SEC legislation is high up on the risks the ADB foresees. Political instability, resistance to reform from vested interest and the lack of interest to improve fiduciary responsibility including CSE-listed requirements and overall market integrity are the risks.

A significant change is enhanced quasijudicial power SEC gains, extending the reach of the current provisions around compounding offences, to deal with insider dealing cases

The attraction of a carrot like a programme loan will be tempting for a cash-strapped government. In the past, what has prevented the SEC from discharging its mandate has been the political pressure brought to bear on the commission, its director general and the management.

Thilak Karunaratne has said publicly that he was requested to go slow on investigations during his first tenure. Other commission chairmen and members have quit in the past, implying that they have been unable to carry out duties.

Channa De Silva, a former SEC director general, is the chairman of the board of Capital Media, the publishers of Echelon. He was not interviewed for this story.

Capital markets the world over don’t expect investors to fend for themselves. It is a regulator’s job to ensure that these individuals investing their savings and portfolio funds, which invest in people’s future retirement benefits, have the benefit of a level playing field. Foreign investors of course have the option to shift their portfolios elsewhere when they feel a market is rigged against them, as they did when the market was heading towards bubble territory. Sri Lankan citizens and companies, unfortunately, are prevented by capital controls from seeking a fairer market or better valuations overseas. So, those seeking exposure to equity in their portfolio have no choice but to brave the elements here.

Foreign investors are now returning to invest in Sri Lanka. However, the market is far from regaining its luster. Sri Lanka’s market has also benefited from an active set of rich local investors, some of whom were speculators, stock price manipulators and insider traders. Fearing prosecution, they have stayed away from the market.

The other absent section is captive savings held in the EPF, ETF and government-controlled funds like Sri Lanka Insurance. Over a long term, equities tend to outperform fixed income in most markets. It’s not a virtue to be shifting asset classes on a whim, but equity allocations in long-term savings like the EPF are woefully low. Without greater participation of these two investor classes, the market may continue in its lackluster way.

Companies with solid fundamentals have outperformed speculative stocks over the last few years, a sign that the market is no longer irrational. Higher interest rates have encouraged deleveraging. With half a decade’s hindsight, it is clear the crisis had multiple causes. The most obvious were stock price manipulators who used techniques such as front running and collusion. Central bankers and other regulators who provided easy credit for too long also bear the blame, for they tolerated this folly. The macroeconomic backdrop was important, too. Sri Lankan investors have few asset classes and a narrow equity market to invest in. Market capitalisation is small relative to the economy’s size, with a tradable value of around 30%. In India, this is 75% and over 100% in most of South East Asia. Stocks and economic fundamentals also haven’t had much in common. Until the stock market better mirrors the economy, its role will remain diminished. However, having a regulatory setup that can meet the challenges of a modern market may nudge a turnaround.