Exacerbated by a seven-week stock market shut down, foreign investors sold large quantities of Sri Lankan bank stocks following a ban on bank dividends this month.
The Central Bank of Sri Lanka (CBSL) in early May prohibited banks from declaring cash dividends for FY20 and foreign banks from repatriating profits until year end to help them maintain appropriate levels of liquidity and manage cash flows prudently amid the Covid-19 pandemic.
Seen as a shock to foreign investors, the move prompted heavy selling in bank stocks by foreigners in mid-May, with Commercial Bank of Ceylon seeing particularly strong selling pressure.
Investors had already been sore from the seven-week closure of Colombo Stock Exchange (CSE) starting from 20 March. When the government eased the lockdown on 15 May, the market reopened, and a 10 percent drop in the S&P SL20 Index triggered a full-day trading halt just 38 seconds after the open.
A day after CSE resumed trading, two major funds – NTAsian Discovery Master Fund and T Rowe Price New Asia Fund– sold a collective 6 percent stake in Commercial Bank, one of the CSE’s go-to stocks.
The share was sold at a 10-year low of LKR 60 a share, which stockbrokers were calling a ‘giveaway’. As foreign institutions sold, stock exchange data shows that the majority of the stock was picked up by domestic firms, including auto groups David Pieris Group and Indra Traders, and jeweler Balasuriya Group.
Commercial Bank is the only bank in Sri Lanka with a high ratio of foreign shareholding – 37 percent as at 31 March. Foreign investors also sold shares in other bank stocks in the aftermath of the CBSL order, such as Sampath Bank and HNB, albeit in smaller quantities.
“US dollar strength, better prospects in other markets, downward pressure on the Sri Lankan rupee, and fund redemptions forced foreign shareholders to dispose of large parcels of investments in our bank,” said S Renganathan, managing director & CEO at Commercial Bank. “Some were planning the redemptions for some time and when the CSE opened they took the money out.”
Further pressure on bank stocks is also attributable to the forward-looking uncertainty the banking sector faces with regard to the Covid-19 pandemic, according to Mattias Martinsson, CEO and CIO of Tundra Fonder in Stockholm. The firm specialises in frontier and emerging markets.
“But what really scared investors was the prolonged shutdown of the CSE, which is why many foreigners sold shares,” he said, adding that foreign investors will now require a higher risk premium for CSE stocks, and will be more cautious when allocating funds to Sri Lanka.
Banking sector pressures
Investors see the outlook for banks as bleak and the sector will have a difficult time growing its business due to the pandemic because of low liquidity and poor portfolio quality, a senior banker at a top Sri Lankan bank noted. “The directive on the cash dividend just added fuel to fire.”
Another banker said that banning cash dividends is the ‘worst sign’ one can give foreign investors, but it’s a good move for the local industry as it will ensure banks retain their reserves.
Another consideration for investors is that GDP expectations are low due to muted loan growth, margin compression amid lower interest rates, and rising loan impairment charges and asset quality pressures relating to the state-declared debt moratorium banks are offering borrowers. This will exacerbate stress on the banking sector’s already weak profitability moving forward.
According to Atchuthan Srirangan, assistant research manager for fixed income and equity for First Capital Holdings, NPLs at banks are expected to peak around 7.2 percent in 2020, recording the highest level in over a decade, before easing off to 5.1 percent in 2021.
“For the first time in two decades, bank profitability may decline for the third consecutive year,” Srirangan says.
Meanwhile, IFRS 9 reporting standards implemented in January 2018, and capital adequacy requirements under Basel III have presented additional hurdles for banks seeking to expand their loan books.
A lack of clarity on state taxation policy, and concerns of Sri Lanka’s ability to repay sovereign bonds that are maturing in a few months have has weighed on foreign investor sentiment, as they are likely to cause further depreciation of the rupee.
Adding to this, Sri Lanka’s foreign reserves have also dropped to USD 7.2 billion as at 30 April, down over 6 percent from end-2019 figures, due to lower inward remittances and export earnings amid the global lockdown.
While this combination of factors has depressed foreign investors’ expectations, some frontier funds are starting to see opportunity.
“In recent days, the CSE has rallied somewhat, as retail investors look to buy in at perceived bargain prices,” said Ruchir Desai, co-manager of the AFC Asia Frontier Fund at Asia Frontier Capital, which has invested in Sri Lanka.
Prohibiting banks from paying cash dividends to preserve capital has been the trend throughout the region, Desai notes, pointing to India, Pakistan, Bangladesh and Vietnam.
He also attributes the exodus of foreign capital earlier this month to the seven-week CSE shutdown, although acknowledging that some foreign investors may have also sold bank stocks due to the current uncertainty in global markets.
Throughout the world, the financial sector has bore the brunt of Covid-19, so Sri Lanka is not on its own in this regard, Desai said. To come out of the woods, Sri Lanka’s high debt to GDP – expected to reach 92.50 percent by year end – needs to be reduced, he said.
In early January, frontier investors like Tundra Fonder were “super optimistic” about the investment opportunities Sri Lanka presented, Martinsson said, highlighting the last November’s newly-elected government and the introduction of tax cuts and other relief measures for the corporate sector.
“We felt that Sri Lanka could be the star of the region. But the pandemic changed the course,” he said. “We are still optimistic that Sri Lanka will come out of this, but we expect a cautious and gradual improvement during the second half of the year.”
What cannot be discounted is that valuations in Sri Lankan banks are approximately the same as in Nigeria – one of the lowest in the world, Martinsson added.
The price-to-book value of Commercial Bank, for example, stands at 0.43x times book, while the smaller Sampath Bank stands at 0.38 times book.
“These valuations are really attractive,” Martinsson said.
Duruthu Edirimuni Chandrasekera is a senior business journalist based in Sri Lanka with over 15 years of experience covering stock markets, banking and trade.