CAPM 2013 highlights capital market avenues of Sri Lanka

By Shabiya Ali Ahlam

Sharing fine insights into the capital markets of Sri Lanka, conceptualised by UTO Educonsult, the Capital Market Conference 2013 facilitated wide-ranging presentations and panel discussions moderated by industry experts.

The comprehensive deliberations were aimed at bridging the gaps between various sectors in the finance industry with the participation of leaders in the areas banking, insurance, stock brokering, mutual funds, venture capital, private equity, and relatively new entrants.

Exploring Sri Lanka’s economic potential

Focusing on the economic potential of Sri Lanka, a panel discussion by CEOs of leading financial institutions exchanged views on a variety of contemporary topics in the area.

Kicking off with the economic outlook of Sri Lanka, HNB CEO Rajendra Theagarajah started by saying that considering the policy framework, the current regime is to focus on a broader view. While matters in this regard seem to be on track, Theagarajah expressed his concerns on the fiscal deficit and stated that policymakers should try their level best to maintain it low.

KPMG Managing Partner Reyaz Mihular shared similar views to the HNB CEO but acknowledged the Central Bank’s initiative in increasing the ratings of Sri Lanka with regard to the ‘Ease of Doing Business’ status.

On the subject of bringing FDIs into Sri Lanka, Mihular stated that few nuisance factors that act as irritants need to be addressed and removed immediately in order to welcome FDIs into the country.

LOLC and CLC CEO Krishan Thilekarathne added to this by saying that concerns prevail in the governance aspect of the county and the current scenario in this regard could question the nation’s stability, resulting in investors thinking twice before moving in.

While focusing on leveraging off Sri Lanka’s potential, Thilekarathne expressed that after 30 years of war, the expected rate of economic growth of the economy should have been much higher, but emphasised that Sri Lanka is set towards the right direction for achieving better economic development.

The panel agreed that current ongoing developments of the country, mainly improvements in infrastructure and active business involvements in diverse sectors, help leverage its potential, but matters should not be left at that.

Theagarajah opined that simply because Sri Lanka is known to be a beautiful destination, investments are not going to flood in and stressed that prevailing potentials need to be made known. He further stated that Sri Lanka has goodwill capital in the Middle East and the maximum opportunity should be taken from it.

Exploring if Sri Lanka can be to South Asia what Hong Kong is to China, Janashakthi Insurance PLC MD/CEO Prakash Schaffter said that Sri Lanka is well positioned for this cause. Few elements that need to be focused on include having active inputs on public debt levels and actually converting the country’s high literacy rate into high IQ levels.

Sri Lanka investing in the upgrade of skills of workforce and allowing easy access to higher education of diverse subjects are few characteristics that allow Sri Lanka to be the hub of South Asia, according to Schaffter. He stressed that Sri Lanka cannot and should not duplicate what Singapore and Hong Kong have done, instead it needs to recognise its potential and strengths, build on them, and aim at making the world its niche market.

Taxation in capital markets

KPMG Partner Suresh Perera expressed that while looking at issuers and investors, room for liquidity improvement, goals, roles and infrastructure should be clear and in place for new products to take off. Commenting on the need to promote Unit Trusts (UT) in order to develop the capital markets, Perera opined the UT industry was a blessed industry in Sri Lanka today. The simple reason for making this statement was attributed to the fact that the normal tax rate in Sri Lanka is 28% whereas the UT tax rate stands at 10% and the rate was extended to the fund managing companies in Budget 2013.

Focusing on issuers, it was noted that only 287 companies are listed in Sri Lanka and in order to improve liquidity in the capital market and increase market capitalisation, a dire need prevails to bring new companies to the stock market.

Looking back, in 1979 the 50% tax rate was brought down to 40% in 1980. In 2000 it stood at 35% and in 2003 the tax was amended to 30%; applicable if the taxable income happens to be more than Rs. 5 million and the company has more than 300 employees in its workforce. In 2006, quoted companies were introduced a rate of 33% and in 2011 the general tax rate was brought down to 28%.

Shedding light on the inconsistency of the Inland Revenue Act, Perera shared that the introduction of 33% tax rate for listed companies in the first five years had not been changed, resulting in every other company being taxed at 28% and quoted companies being taxed at a higher rate. “This mistake should be rectified and I don’t think anybody has noticed it,” he said.

In the last Budget bringing out an appealing tax incentive, only 50% of the tax is payable in the first three years provided 20% shares of the company are with the general public for newly-listed companies. However, looking at the Budget Speech and the technical terms, according to Perera one would find in the body of the speech, on page 46, for companies listed before December 2013 the half tax holiday in the first three years will be applicable but the technical notes say differently. They mention that any company listed after April 2013 can make use of the incentive. “If we take both as correct, only companies listed after April 2013 and before December 2013 will have access to tax incentive,” he said.

Recognising prevailing tax incentives in Sri Lanka for investors, income tax and stamp duty exemption for listed shares are offered provided that share transaction levy is paid. Tax reduction for capital expenditure for stock brokers is also obtainable. The 2013 Budget introduced a new rule for fixed interest debt security where the tax is to be deducted upfront and in-terms of floating rate the interest will be deducted in instalments.

Ensuring the corporate debt security market functions smoothly, a proposal was introduced to exempt interest income for listed debt securities in the Colombo Stock Exchange after 1 January 2013. If investing in Treasury bills and bonds, the tax rate applicable is of 10% while no tax will be charged when investing in listed debt securities.

Escalating market capitalisation

Increasing market capitalisation in the Colombo Stock Exchange, Capital Venture Lanka Chairman Channa de Silva expressed the need to bring in at-least two more companies to get the market elevated from the Emerging Market Index for Sri Lanka to get reflected in the radar of foreign countries. He professed that in terms of tax incentives, many companies would take the prevailing advantage and apart from the equity side, the corporate bond market shows immense potential convincing the treasury to withholding the tax element completely. Silva acknowledged that from the Government’s point of view, everything possible has been done and it is now in the hands of the issuers to make use of the situation.

A surge of interest in the corporate bond space is expected. Vidullanka Managing Director Riyaz Sangani stated that the Government policy has been that there will not be any privatisation but certain State companies are showing keenness on being listed. He opined that the Government entities accessing the market via the debt route should be explored. Sangani highlighted that companies enter the market for capital needs and not to make use of the new attractive tax incentives.

Abdeen Holdings CEO Omar Kayaam pointed many companies choose to go public to settle conventional debts and unlock potentials. Debating if family-owned companies once public would enhance their endurance, the panel agreed that it would indeed lead to longevity as the company is answerable to its shareholders once listed, thus would work towards giving higher returns to satisfy them and remain competitive in the market.

Explored challenges on family-owned companies going public included committee members who are family-owned company members having their own objectives and difficulties in shifting from a family culture to a corporate culture.

Securities and Exchange Commission (SEC) Director Vajira Wijegunewardana stressed that private equity investments in Sri Lanka had their own cocktail of problems. Interested parties would have to borrow at 20% interest rate to invest in private equity, resulting in young corporates having difficulties in accessing finances. Wijegunewardana stated that the Sri Lankan mindset on local grounds is short term and for serious talk with international investors, broader country risks will have to be specifically assessed.

Governance was also noted to be a challenge for local markets. On the forum, Wijegunewardana requested senior level representatives of the SEC to bring back listing introduction to the regulatory preview even though a few small scale companies had exploited the avenue in the recent past. He concluded by saying that as the regulator SEC needs to balance all aspects and take the best action forward.

Insight on the UT industry

Sharing insights on the potential industry, UT Managers Association President P. Asokan expressed his views on UT as a connective investment scheme comprising of taking money from diverse investors and investing it in different asset classes, with the returns distributed to investors.

UT having two components – financial capital and the trustee – a UT is regulated and licensed by the SEC. Where the ‘trust’ component is concerned, the trust is to protect the interest of investors and assets of the fund have to be under the custody of the trustee. UT also being regulated by the UT code, a comprehensive document is signed by the trustee and the financial managing company, binding them together. The document specifies how the UT is operated while investment parameters, duties and responsibilities of both parties are well defined.

The UT code, which is common to all in Sri Lanka, gives the general idea on how the UT would operate, specifying the fund management company is to make the investment decision and to be conveyed to the trustee. The decision being made, the trustee is under no obligation to disperse funds based on it. The trustee has the freedom to venture if the decision is in conformity with the investment parameters specified.

Perera opined that despite the UT industry being 20 years old, it still hasn’t taken off as expected despite its potential as banks and finance houses choose not to promote the product thinking it would affect their targets in deposits.

Popular culture in Sri Lanka is to invest money in fixed deposits; the mindset of the people does not accommodate the willingness to receive variable returns over period of time. To take UT forward, Perera stressed that other channels of distributions would have to be tapped; post offices and supermarkets need to be explored to make the product available.

The CSE and the SEC share the view that the ideal investment option for small investors to benefit from the capital market is through UT and a certification program is in the midst of development for those willing to market the UT among the general public.

New market place for commodity trading

Assessing the pros and cons of derivatives, the panel discussion on ‘Introduction of new products’ recognised derivatives as a useful and necessary investment tool where the pros of such trading outweighs the cons. Identified advantages of derivatives include risk mitigation, contract flexibility and leveraged speculation while its disadvantages are directly related to the misuse of products, which result in large losses.

SEC Director Surveillance Namal Kamalgoda shared that an expression of interest was called from the Commodities Exchange of Sri Lanka and a number of encouraging applications were received. Issues exist in evaluating the proposals as technical experts are unavailable in Sri Lanka for the review and the SEC is looking at bringing experts from abroad for the same.

Nithya Partners Partner Neomal Goonewardena stated having the legal framework in place, the prominence in the current securitisation results in the structure amounting for UTs. He further stated that having securitisation cannot satisfy the requirements of UTs as there is no capital management and the said is the legal impediment that prevails with regard to listing of securitised instruments.

Moving the dialogue towards short-selling, Goonewardena expressed uncertainty has been lingering as on policy basis no decision has been made as yet whether or not to continue short-selling. While he said the premature short-selling should nevertheless be allowed, he stressed that when introducing derivatives and commodities exchange, the first that should be ticked off the checklist is calling for proposals and preparation from consultants for proper tax framework before introducing new products.

Adl Capital Associate Director Sabri Cader opined it is mandatory for stockbrokers to be extremely fluent on short-selling products and strong regulatory regime will have to be practiced by stockbrokers to ensure short-selling is used and not made substandard.

Growth of Islamic finance and its potentials

Acknowledging the steady growth of Islamic banking in Sri Lanka over the past few years, enlightening the audience, market leaders in that industry shared their success stories. While LOLC is slightly more mature in the Islamic finance market compared to HNB and Commercial Bank, the three players conferred that they set foot into Islamic banking market as the market and demand for such products have been evidently growing over the years.

Customers specifically requesting of Islamic finance products, the market potential was recognised, enabling transaction via the Islamic route. HNB Deputy CEO Jonathan Alles said the bank was seeking to venture into Islamic banking in 2007 but the dialogue lost steam but heightened in 2010 and Islamic finance windows were made available soon after.

IBU Commercial Bank Senior Manager Feroza Ameen stated the bank noticed falling numbers in its customer base and realised Islamic finance would have to be offered to retain them. With the Banking Act No. 30 of 1988 being amended in March 2005 accommodating Islamic banking, Commercial Bank grew comfortable and confident to explore the new option.

Al Falaah Chief Manager Shiraz Refai shared similar views for LOLC adding Islamic finance to its portfolio and said the company is indeed highly-satisfied with the results of the new product offering. The three financing houses shared the challenges faced in implementing the concept and expressed that it was not easy to convince the top heads on the need and potential for Islamic finance as cost for providing Islamic finance instruments is higher than the cost of offering the general conventional instruments.

Alles said the HNB is looking to add more products to its Islamic banking portfolio and the team has met up with Sharia scholars on a few product innovations the HNB plans to offer within the next few months. The Islamic banking industry which accounts for 10% of the market share would see higher growth rates within the next two to three years, according to Alles.

Refai added Al Falaah is aiming at introducing new products every year to remain competitive in this market. When questioned on the ‘Al Falaah’ name to tag the product range, Refai said that LOLC sought to differentiate itself from others and wanted to brand its products with a name that is closer to their customers. The Arabic terminology ‘Al Falaah’ meaning success, Refai passionately said that the institution wanted to share its success with the success of its customers, thus the name and strategy was applied.  Diverting focus to the development of Sukuk in the booming industry, KPMG Partner Suresh Perera professed that the Sukuk market had the potential to attract investors to fund infrastructure and development projects. As means of attracting finances alternative to conventional sovereign bonds, Sukuk should be explored to bring liquidity from the Middle East.

Value of audits

While the audit concept would have diverse meanings to different groups of people, it typically ensures a company’s compliance to regulations while it closely looks at internal control processes and financial reporting systems. It brings to light prevailing financial reporting flaws and risks, giving companies the allowance to understand, respond and mitigate towards highlighted issued.

KPMG Partner Head of Audit Suren Rajakarier shared his experience on audits during his presentation on the value of audits in capital market credibility.

With audit functions sounding similar to the functions of rating agencies, both look at similar aspects, according to Rajakarier.

“An audit is similar to a health check as it merely gives an opinion and not advice on how to improve the status of a company,” he said. An audit would declare that the financial statement presented is true and fair, whereas it will not affirm it to be correct based on the information provided.

To understand what an audit does not do is easier than understanding what it does. An audit does not; say the company will do well or not in the next few years, it doesn’t give the approval of a financial company being good, it doesn’t speak about the efficiency of the management, it doesn’t help in preventing non compliance and it certainly doesn’t prevent frauds from taking place.

Along with noticing potential risks, only typical elements similar to penalty fees would get captured in an audit report. Rajakarier stressed that while conducting audit functions, it is mandatory to have access to all relevant and required information and high dependency prevails on the integrity of the management to successfully complete the process.

Prevention to be exercised via internal control systems through management attitudes towards controls, Rajakarier expressed that if the Chairperson and the Board of Directors (BOD) of a company are corrupt, in no possible way of having internal control that can prevent frauds from happening. He shared that in every instance where frauds had been detected, the situation which was reported upwards had abruptly stopped from any decision by the BOD as they overlooked the scenario only to collapse the proceeding year for not being able to sustain the environment. Key management persons need to be truthful and all transactions should be disclosed for the process to be affective. Issues with regard to audits in managements include; lack of understanding and limitation of audits, and lack of transparency by companies. Tangible benefits of conducting audits is that it allows access to capital, low cost of capital, better forecast of investment advisory, reduces prevailing risks, and helps maximising profits by increasing efficiency of the fund managing company.

 – Pix by Sameera Wijesinghe

and Lasantha Kumara