Though the war is over in 2009, the share market in SriLanka has not been functioning successfully.

You are required to provide the reasons for such inefficiency in operations.

Introduction
The Colombo Stock Exchange (CSE) is the main stock exchange in Sri Lanka. It is one of the most modern exchanges in South Asia, providing a fully automated trading platform. The vision of the CSE is to contribute to the wealth of the nation by creating value through securities. Even though it is one of the modern exchanges in South Asia, now the confidence in CSE is becoming decreased. The civil war ended in 2009 and as result it was expected that the share market in SriLanka will boom. But, actually it was not the case. Though the data shows there is increased tendency in ASPI after 2009, reality is there is inefficiency in the operations of CSE. The following reasons are explaining why the share market in Sri Lanka is not functioning successfully after the war.

1. The main reason for the unsuccessful conduction is due to the erosion of confidence in the CSE as result of their inefficiency in operations. The inefficiency was caused by two factors: 1.1 Market Manipulation 1.2 Insider Trading

1.1 Market Manipulation

This refers to the deliberate interference in the free and fair operations of a financial market. The aim of manipulation is to paint a false picture of the market, misleading investors and analysts. The CSE has been plagued by a barrage of market manipulations in the recent past. The All Share Price Index shows a dramatic increase after the end of the war. But it had been caused by the market manipulation. The following column chart depicts the ASPI trend from 2000 to 2012.

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ASPI
7000.0 6000.0 5000.0 4000.0 3000.0 2000.0 1000.0 0.0 2,000 2,001 2,002 2,003 2,004 2,005 2,006 2,007 2,008 2,009 2,010 2,011 2,012 ASPI

According to the image above, the ASPI suddenly increased after the war and then started to decrease from 2010. The following line chart shows the monthly trend in ASPI from January 2009 to June 2013.

ASPI
9,000.0 8,000.0 7,000.0 6,000.0 5,000.0 4,000.0 3,000.0 2,000.0 1,000.0 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 ASPI

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According to Bandula Sirimanna, the drama began in mid-2009 just before the war ended with the All Share Price Index (ASPI) running at 1,500 points and a market capitalization of Rs. 1 trillion approximately. He noted that the impact of the war victory was immediately seen with the market creating wealth and realizing wealth that was suppressed during the over 30 year war. After two years in February 2011, the ASPI shot up to 7800 points, a market capitalization of Rs.2.3 trillion and an average turnover of Rs. 2.3 billion, he added. At 7,800, the market didnt look healthy with unrealistic Price Earning levels. Company share prices were highly inflated mainly as a result of mid cap stocks by a few net worth investors, he disclosed. This was a highly unrealistic situation created by manipulators, he said, adding that they identified mid cap stocks with a very low public float for their sinister move. The modus operandi was that they obtained free unlimited credit for the small investors that gave liquidity to them and drove prices up to very unrealistic levels. After that they exited leaving the stocks in the hands of the small investor who borrowed money for these schemes thus making the Colombo stock market an inefficient one. The high daily turnover was a result of this, he said. Then the regulator Securities and Exchange Commission stopped unregulated credit to protect small investors. As a result small investors have now been driven away from the market as they have lost more than they had as a result of credit. The market crashed due to prices tumbling down as a result of manipulation with credit and force selling. With the impact of the war victories, the market should have risen to only a realistic 6,000 points and not a manipulated unrealistic 7,800 points. If the market settled at 6,000 points in February 2011 at a realistic growth of around 25 per cent, the indices would have reached 9,000 points and resulted in a healthy market cap of over Rs.3.5 trillion now, he concluded. Some examples for market manipulation in Sri Lanka In 2011, the Employees Provident Fund (EPF) bought an 8% stake in Laugfs Gas PLC for Rs.1.6 billion, pushing share prices up to between Rs.38-41 per share. However, through this inflation of share prices, the stock was sold at Rs.51 per share before coming down to Rs.40 that same day. As at July 4, 2012, the share price of Laugfs Gas PLC is Rs.19, amounting to a loss of Rs.1,389 million to the EPF. It is clear that the brokers involved made a massive profit by artificially inflating share prices. This example highlights another problem which is a misuse of the public funds The manipulation described above is but one example of a myriad of pump-and-dump rackets witnessed on the trading floor. It involves the overvaluing of shares so that stockholders are able to sell their shares at an artificially inflated price. However, this comes at the expense of another party, in the example above the loser is the pool of EPF funds.

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Another example of public funds being used in a pump-and-dump transaction is that of the EPF purchasing stock in Galadari Hotels (Lanka) PVT Ltd. in 2010. The EPF purchased 23.7 million shares in the company, at Rs.32.50 a share. The value of these shares, as at July 2012, is at Rs.11 per share, which amounts to a loss of Rs.500 million. The previous owners of the share, Nawaloka Hospitals was reported to have been relieved to have gotten rid of the burden of the loss-making Galadari Hotels (Lanka) PVT Ltd. It is convenient that a lossmaking company was transferred from private stockholders to an institution that deals with public funds. The total value of losses incurred by the EPF in the stock market is placed at over Rs.4 billion, according to Economist Dr. Harsha De Silva MP. Because of the market manipulation Sri Lankas tiny stock exchange is losing billions of rupees in value creation and becoming illiquid. The country has lost around Rs. 1.5 trillion in terms of value creation to the economy solely as result of those who manipulated the market from 6,000 to 7,800 points (ASP index)

1.2 Insider Trading

Insider trading is another form of market manipulation. It is the unfair use of trading by those within privileged access (insiders) to information that has not been disclosed by a company to the public (undisclosed information) and which information would, if made public, have an impact on price of securities of that company. The EPF also made clear its adherence to accounting standards and credibility of internal auditing procedures, rebuffing Dr. Harsha De Silvas claims of market manipulation by alleging he had a political agenda behind his analysis. However, once we move past the jaded political rhetoric of our Sri Lankan institutions and politicians, we find it hard to disregard the evidence of massive loss-making investments made by a company that deals with public funds. Laugfs Gas PLC, Ceylon Grain Elevators, Brown and Company, Galadari Hotels and The Finance Company all appear to be unsound investments, incurring huge losses to the EPFs pool of public funds. An article titled Insider Trading Unavoidable? published in 2011 sheds light on a peculiar detail of Sri Lankas investor community; the geographical distribution of stock market players aids in the speedy transference of material information. Nimal Perera, an investor at the CSE, mentioned that we are all insiders, including the regulators, as we are a close -knit society.

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These controversial remarks highlight not only the ease with which material information may pass through investor circles, but also the callousness with which perpetrators may publicly claim their nefariousness. The article goes on to describe the two types of insider traders Primary insiders, who have access to material information and Secondary insiders, those who obtain material information from primary insiders. Although conflicts of interest might not be a form of market manipulation, it is worth exploring the role they play in the erosion of fairness and transparency on the trading floor. A scandal in the recent past is that of the National Savings Bank (NSB) purchase of The Finance Company (TFC). In a nutshell, this scandal is concerned with the purchase of 13% of TFC by NSB for Rs.49.74 a share, whereas typical share prices were at Rs.30. Following public disclosure of this deal, President Mahinda Rajapaksa halted payment and ordered Secretary to the Treasury, Dr. P.B. Jayasundera to initiate an investigation into the deal. The 13% of TFC shares were to be purchased from two of the companys Directors, Dinal Wijemanne, CEO of Taprobane Securities and Raynor De Silva, ABC Radio Managing Director. It came to light that there is a conflict of interest at hand; Taprobane Securities was the firm that authorized the purchase of these shares and the director of the company was the individual selling these shares. As Warren Buffet once said, Earnings can be pliable as putty when a charlatan heads the company reporting them. A Sri Lankan example of this is the case of Watawala Plantations. Recently, the directors stripped the company of its marketing division with no prior consultation with the shareholders. Arbitrary decisions made without the consultation and consent of the stock owners points towards serious concerns over the transparency and good corporate practices of the directors. This section was sold for Rs.741 million when the companys true value stood between Rs.2.5-3 billion. In this case, it is hard to see who gains from manipulating the market, yet it is easy to see how poor corporate governance leads to slights on the trading floor.

The question of who is involved with market manipulation is somewhat complex in its dimensions. As we can see from the examples cited in this document, the perpetrators are high ranking executives and stockbrokers. The misuse of public funds seems to allude to the fact that there could be rouge political elements at play.

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2. Composition of Investors

The Sri Lanka stock market has more retail investors than institutional investors thus resulting it to be more short term gains driven versus long term. If you ask a layman how he or she thinks of investing in the stock market, the general perspective is that the stock market is a place where people have lost their hard earned money. This sentiment was a result of a market correction that took place in 2011 and which continued till mid 2012. The correction is a term used by stock market analysts to define behaviour of a market where a market takes a break from a rapid rally and moves in the opposition direction temporarily. This phenomenon took place at the Colombo Stock Exchange after the stock market gained more than 100% for two consecutive years after the end of the war. Even though the stock market has gained by more than 100% for two years, and lost only about 20% since it hit peak in February 2011, an average person in Sri Lanka sees it as a place where people lost more money than they gained. A layman to stock market investing would think why is that? as people technically should have made more money than gained. The answer lies in the investors investment/trading pattern that has resulted in losing much more money than they have gained. One of the reasons for the losses is the late entry into a bull market. But that is only a part of the story as most of the investors who made losses have actually participated in the bull rally in 2009 and 2010, but subsequently lost the money. The main reason is as we discuss in the next paragraph is the individuals tendency to look for short term profit by trading in the market. If it was possible for you to invest in All Share Price Index (ASPI) and hold it for five years, during last 10 years you would have never recorded a loss. In other words if you held on for your investment in the Colombo Stock Exchange for at least five years in any date you have invested in from 2003 to 2013 it is not possible for you to lose the money on the ASPI. This reflects a basic characteristic of equity investments.

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Equity investments yield best investment characteristics when you invest for the long term. The table above explains that the long term investments are profitable than short term investments For example, the annualized return of AHPL for 1 year is 1.43% where as its 5 year return is 37.35%. But if you try to beat the market by trying to buy the shares and sell the shares, trying to predict the share prices high and low, it will be incredibly difficult task (almost impossible task) to profit from the market for a general investor as there is considerably high psychological risk premium in short term trading.

3. Shareholder fatigue

Another consequence of market manipulation is shareholder fatigue. This is a phenomenon that occurs when minority shareholders do not receive dividends on their preferred stock. As company directors become tied up in the profit reaping on their manipulations, their companies usually suffer under long-term over valuation of stock. As in the case of Watawala Plantations, ordinary shareholders are denied the right to exercise control over their company. Market economics dictate a divorce between company ownership and control, yet ordinary shareholders are presented with voting rights (whereas preferred stockholders typically do not receive voting rights) to steer the direction of their company. Market manipulation allegations, whether proven or false, deter investors from entering the trading floor.

4. Stock Market Bubble

A bubble occurs when share prices are inflated to levels higher than their real value, usually through dissemination of false performance rumors by brokers and a myriad of other market manipulations and investor speculation. Brokers have a heavy hand to play in the creation of a bubble, as they gain on the commission received from brokering stock transactions. A group of high net worth individuals prop up the market through the purchase of illiquid stock (also known as penny stocks). The stock market crash of 2011 persists today, with a year-to-debt ratio of 20% reported in May 2012, which amounts to a loss of Rs.40 billion. We can now clearly see how brokers and investors play a crucial role in preventing a bubble from forming. Yet, in the Sri Lankan context, this responsibility is rarely carried out. We also see how one market manipulation can lead to a variety of unintended negative effects, i.e. overvaluation of stocks leading to a stock market bubble and subsequently, a crash.

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5. Free floats Many companies have very negligible free floats (Example: Nestle)

6. Tendency to invest in Fixed Deposits

There is considerable risk in investing in the Colombo Stock Exchange. Equity investments in stock markets do not give guaranteed returns as fixed deposits and the prices of the shares can be quite volatile. Small scale investors are afraid of getting their investments lost in stock market and prefer to invest in FDs. Because, risks of fixed deposits are considerably low, especially in terms bank deposits of which up to Rs. 200,000 are insured by Sri Lanka Deposit Insurance Scheme. Fixed deposits give moderate returns with guaranteed interest receipts, and there is virtually close to no risk in losing the capital, especially in terms of deposits in banks.

Summary
Though the war is over in 2009, the share market in Sri Lanka has not been functioning successfully. The main reasons are: 1. Market has been manipulated to an excessive level to show an unrealistic ASPI of 7800. As a result, small scale investors were driven out of the market. 2. Insider trading is taken place by especially some political elements. 3. Short term investors lose their money compared to long term investors. 4. White-collar crimes involving the rich stealing from rich NSB Scandal 5. Shareholder fatigue Preference shareholders 6. Stock market bubble

Unless some action is taken to re-establish confidence of investors and regulate trading with the intervention of the President, no one can prevent the deterioration in the market.

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References

Bandula Sirimanna Business Times (July 21 2013), Stock Market: Glass Is Not Half Empty Its Still Half Full, retrieved from http://www.sundaytimes.lk/130721/businesstimes/stockmarket-glass-is-not-half-empty-its-still-half-full-53024.html CSE Data Library, Annually Summarised Trading Statistics, retrived from http://www.cse.lk/data_library.do CSE Data Library, Monthly Summarised Trading Statistics, retrived from http://www.cse.lk/data_library.do Daily Mirror (8th Oct 2013) , Manipualtion in the Sri Lankan Stock Market, retrieved from http://www.dailymirror.lk/business/features/20787-manipulation-in-the-sri-lankan-stockmarket.html Forum Discussion at http://forum.srilankaequity.com/t31061-unsuccessful-share-market-insri-lanka#183216 Shehan Bartholomeuz LOLC Securities Limited (2005), Selecting Between Stock Market Investments and Fixed Deposits , retrieved from http://forum.srilankaequity.com/t29673selecting-between-stock-market-investments-and-fixed-deposits Wikipedia, Colombo Stock Exchange retrieved from http: //en.wikipedia.org /wiki / Colombo_Stock_Exchange Zeena Sathar, Team HR, AMBA Research Zohair Haiderally, AMBA Research

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