Bond Market Development in Sri Lanka

C.J.P. Siriwardena,
Additional Superintendent,
Public Debt Department
Central Bank of Sri Lanka
(A Paper presented at the UN-ESCAP Regional Workshop on Capacity Building for
Development of Bond Markets in ESCAP Member States at UNESCAP, Bangkok)

PART I: OVERVIEW OF THE ECONOMY AND FINANCIAL SECTOR1/

1. Overview of the Economy
Sri Lanka is a small open economy with an estimated population of 20.1 million and an annual average
population growth of 1.1. per cent . The economy has grown on average by 5 per cent over the last
fifteen years. The gross domestic production in 2006 is estimated at US$ 28.1 billion with a per capita
income of US$ 1,414 that falls the country into a group of lower middle income countries in the world.
The overall performance of the economy has moved to a high growth path and able to maintain growth
momentum in real term over 6 per cent in the recent past. The economy achieved a commendable
growth of 7.7 per cent in 2006 and 6.2 per cent in the first half of 2007 and is estimated to grow at
6.7 per cent in real term in the year as a whole. In 2008. the economy is prospected to grow at a higher
rate of 7.0-7.5 per cent. The medium term development strategy expects to broad base activities
thereby maintain over 8 percent annual growth over next 10 years enabling the country to reach its per
capital income over US$ 3,000 level (Appendix Table 1).

2.

The economic activities are broad based and the overall production is an outcome of the

performance of the three main sectors; services, industry and agriculture sectors in the economy. The
services sector has shown a steady growth in its share in the overall production and today plays a
dominant role accounting for over 56 per cent of output in the economy. Main services sector activities
include international and domestic trade, financial services and transport sector contributing for 70 per
cent of the services sector output. The industry sector share in the total output remains around 27 per
cent over last three decades period. At present, factory industry and the construction sectors contribute
a prominent role accounting for over 75 per cent of total industrial output in the economy. The
agriculture sector which was the major sector in the economy, five decades before, contributes for
only 17 per cent of the total output in the country. Food and plantation crops sectors represent over 80
per cent of the agriculture sector output. The performance of this sector is highly sensitive to the
weather conditions prevail in the country which follows a cyclical pattern impacting volatility in the
annual production process. Despite Sri Lanka is an island economy with unlimited marine resources, a
share of the fishing production in the overall productions is less than 2 per cent.

3.

The economy has been continuously running with the domestic resource gap where countrys

investments are higher than national savings and financing the gap through foreign sources. Both
investments and national savings are in the upward trend, reached to 28.0 per cent and 22.9 per cent of
GDP respectively in 2006. However, as the current level of savings and investment is not adequate to
1

The views expressed in this paper are the authors own and do not necessarily reflect those of the Central
Bank of Sri Lanka. The structure of the paper is based on the outline provided by the UNESCAP to the
regional workshop.

take off the economy to a targeted high economic growth path in a sustainable manner, the medium
term macroeconomic strategy expects to enhance the countrys investment over 30 per cent of GDP
giving high priority on more productive sectors in the economy.

4.

The government has reiterated

the necessity of bringing the fiscal consolidation in order to

ensure the fiscal as well as debt sustainability in the country. Persistently high government budget
deficit which was largely financed through commercial type domestic borrowings resulted for the
mounting debt stock in the public sector in the recent past. In this context, servicing of public debt
became a major issue in the government budget and the management of public debt became a
complex task which requires drastic changes to the overall fiscal and public debt management in the
economy. Understanding the emerging threats in the fiscal sector, Fiscal Management (Responsibility)
Act (FMRA) was brought into the system in 2003, in order to

improve fiscal discipline and

transparency in fiscal operation through rule based fiscal management as practicing in many other
countries in the world.

5.

Under the FMRA, the government has committed to bring down the overall deficit to below 5

per cent of GDP in the medium term and lower the total debt to GDP ratio to 60 per cent by 2013. The
government expects to achieve these targets through more sustainable approach by enhancing revenue
efforts, streamlining recurrent expenditure while allocating more funds for public investment and
accelerating growth movement in the future. The government budget 2008 has been formulated toward
this direction generating surplus in current account operations thereby limiting government borrowings
only for public investment activities of the government. Debt to GDP ratio that rose to over 105 per
cent in 2004 is already in the downward path and estimated to decline to 85 per cent by end 2007.

6.

The external sector operations of the country recorded a substantial expansion in external trade

and financial flows that is helpful to maintain surplus in the Balance of Payment (BOP) in most of the
years in the recent past. Although export sector maintains a high growth with continuous diversification
of products range, countrys trade balance remained over 10 per cent of GDP in the recent past mainly
due to sharp increase of international prices of intermediary goods such as petroleum oil. However,
large and steady growth of the inflow of private remittances which becomes a permanent and growing
foreign exchange earning source help lower the current account deficit of the BOP to around 3 per
cent of GDP. Even though, the economy has an inherited feature of running with current account deficit
in the BOP, the overall balance of the BOP has been mostly positive due to high inflow of funds
received for government budgetary operations and continuous flow of funds through private remittances
and foreign direct investment into the economy. In 2006, the overall balance of the BOP was US$ 204
million and expected to generate surplus of US$ 450 million in 2007. The gross official reserves of the

country gradually increased up to US$ 2.5 billion at end 2006 and further to US$ 2.6 billion at end
August 2007 enabling to maintain around 3 month of import of goods and services. In line with that,
total external reserves of the country grew to US$ 4.0 billion at end August 2007and it was sufficient
for over 4.3 month of imports of goods and services in 2007. Maintenance of external reserves at this
level shows the resilience of the economy to unforeseen external shocks in the future.

7.

Sri Lanka entered into Article VIII agreement with the IMF under which current account

operations are fully liberalized since 1994. In addition, part of the capital account operations is also
liberalized with the intention of continuing the opening path gradually in the future. Sri Lanka has
made continuous

efforts to strengthen the external trade relations through bilateral, regional and

multilateral trade arrangements in order to boost activities in the economy.

Of which, bilateral

agreements with the EU and India are major events. Even though series of measures has been taken to
encourage Foreign Direct Investment (FDI) by granting various incentives and creating conducive
infrastructure for foreign investment in the economy, foreign direct investment remained low around 1
per cent of GDP over the past. Understanding the importance of increasing FDI in achieving future
growth target in the economy, government has been formulating a new strategy to increase FDI that
helped to increase it to 2 per cent of GDP in 2006 and further increase in the future.

8.

The Central Bank conducted a tight monetary stance in the recent past with the objective of

containing inflationary pressures and lowering the rapid growth of monetary aggregates in order to
facilitate the high growth momentum of the economy. The Central Bank relies more on market-based
instruments such as Open Market Operations (OMO) to conduct the monetary policy with a view of
maintaining the price stability in the economy. The financial sector continuously expanded with
improved stability and resilience over the past. The performance of financial institutions improved in
terms of profits, soundness and a widening of the array of financial products and services. The market
infrastructure covering regulatory and payment and settlement systems has been substantially improved
to enhance the efficiency in the financial system while ensuring protection to all stakeholders. The
banking sector intermediation in the corporate sector is excessively high and their funding requirement
is almost entirely met through the banking system in the country.

2) Policy Environment
9.

The macroeconomic management in Sri Lanka has been centered around fiscal and monetary

policies system in order to take off the economy toward a sustainable high economic growth path with
balanced regional development. The fiscal policy has been formulated toward achieving fiscal
consolidation while monetary policy focused on prudent monetary management and a well functioning

independent floating exchange rate system. This process has been complemented by the broadening and
deepening of structural reforms in order to enhance the efficiency in policy transmission and to ensure
the targeted outcome in the future.

10.

The fiscal policy framework has been formulated mainly focusing on the fiscal consolidation

programme which is compatible with the medium term fiscal and debt sustainability strategy outlined
under the Fiscal Management (Responsibility) Act (FMRA). The FMRA aims at among other things
two major problems in the fiscal sector; persistently high budget deficit and high public debt stock and
therefore, envisages to reduce the overall deficit gradually to below 5 per cent of GDP and lower the
debt to GDP ratio to 60 per cent by year 2013. The work plan incorporated into the medium term fiscal
consolidation programme include the turning round of current account deficit ( or dis-saving of
government which has been a permanent feature in last two decades) to a surplus through expanding
tax base, high non-tax revenue efforts from state enterprises, cost effective expenditure management
system together with prudent debt management policy and phasing out of budgetary transfers to public
enterprises. While achieving the medium term fiscal consolidation targets, the fiscal policy also
designed to support economic growth, implementing structural reforms and generating productive
employment in the economy. In order to address regional imbalances and high degree of poverty in the
economy,

pro-poor, pro-growth and regional development strategy has been introduced to enhance

the standard of living of low income people and vulnerable groups in the society. This programme is
expected to be implemented through the development of socio-economic infrastructure facilities,
creating employment and income opportunities

for the poor, minimise regional imbalance in

development and distribution of benefits of growth.

In order to facilitate this programme, the

government has determined to increase allocation of resources for the medium term public investments
programme giving more priority on infrastructure development to create a conducive environment for
private sector investment to accelerate growth momentum in the economy.

11.

In line with the medium term fiscal strategy, the preparation of the government budget is an

annual process for a rolling period

of 3

years. Accordingly, Medium Term Fiscal Framework

(MTFF) has been developed consistent with the overall medium term macroeconomic framework.
Further, the MTFF explains its financial flow, toward specific targets within the context of sectoral
policy strategies. Since the annual budget is published as a rolling plan, the implementation agencies
have flexibility to revise their work plan in advance as and when required, thereby ensuring the
implementation of the medium term programme as expected originally.

12.

The monetary policy stance in Sri Lanka aims at achieving a suitable low and predictable level

of inflation, which support economic activities of the economy. The Central Bank as monetary authority

of the country formulates a monetary targeting policy framework to guide the monetary policy
operations. At present, the key policy instrument is the Central Bank Policy interest rates (Repo and
Reverse Repo rates) maintaining using the active open market operations. The open market
operations(OMOs) enables the Central Bank

to actively manage market liquidity to achieve its

monetary policy targets. The Central Bank conducts several operations; conducting auctions, standing
facilities and outright sale or purchase to maintain liquidity position in the market at desired level. In
this process, government securities i.e. Treasury bills and Treasury bonds play an important role in the
OMOs. In addition, Statutory Reserve Requirement (SRR) on Licenced Commercial Banks is also
used as a direct instrument to support the monetary policy operations.

13.

Since 2003, the Central Bank has been adopting a tight monetary policy stance to curtail credit

growth as it is considered as one of the causal factor in rising inflation in the economy. Accordingly,
Central Bank policy rates revised upward by 9 times during the period 2003 2006, increasing the repo
and reverse repo rate structure by 300 bps from 7.0 8.5% to 10.0 11.5% over the period. In 2007,
policy rates revised upward again by 50 bps. to the current level of 10.5 12.0%. A cautious
approach has been adopted in open market operations to restrict the injecting of funds from the
Central Bank to the system while maintaining the market liquidity at required level in order to
accommodate smooth transaction in the economy. In addition, several specific prudential requirement
measures have also been imposed on commercial banks in the recent past to curb the rising credit
growth in the banking system. Beginning 2007, the Central Bank has issued its Roadmap for Monetary
and Financial Sector Policies for 2007 and Beyond, explaining the policy strategy to be introduced to
maintain the economic and price stability and the financial sector stability of the country.

14.

In view of external sector policies, replacement of the managed float exchange rate regime by

the independently floating exchange rate regime in 2001 was a major policy move in the recent past.
The new regime is expected to strengthen the exchange rate stability, deepen the foreign exchange
market and improve the countrys competitiveness in the international market . Reflecting the
effective implications of the new exchange rate policy, countrys total external assets measured in
terms of months of same year imports, increased to 4.7 months by end of 2006 from 3.5 months in
2001. The current account operations are completely free from exchange controls, while capital account
is partially opened specially allowing foreign investors to enter into selected markets and sectors in the
economy. Although, equity market is almost fully opened for foreign investors, money market is still
restricted for foreigners. In 2006, government bond market was opened for foreign investors with a
limited access (5 per cent of outstanding total Treasury bond stock) facility. However, more restricted
policy has been adopted on local investors investing in foreign market which is permitted only on
case by case basis.

3) Financial System
The financial system plays an important role in financial intermediary functions by borrowing from
surplus units and lending to deficit units in the economy. The financial institutions comprise the Central
Bank which stands as an apex institution responsible for monetary and regulatory authority of the
financial system and other financial institutions which dominated by Licensed Commercial Banks
(LCBs) in the country. The financial markets in the country consists of inter-bank call money market,
domestic foreign exchange market, government securities market, share market and corporate debt
securities market. Except corporate bond market, all other financial markets are active and operate
largely through various instruments. Financial infrastructure, which covers regulatory framework and
payment and settlement system, facilitates the smooth and efficient transaction in the financial market
and provide safety to all stakeholders in the financial system (Appendix Table 2).

3.1 Central Bank

The Central Bank, since its inception in 1950 under the Monetary Law Act has been responsible for the
administration, supervision and regulation of the monetary, financial and payment and settlement
system in the country. Until 2002, the Central Bank had multiple objectives relating to the stabilization
of domestic monetary value, preserving the stability of the exchange rate, promotion of high level of
production, employment and real income and the encouragement and promotion of the full development
of productive resources of the country. With the evaluation of economic and financial sector operations,
it has been realised that it would be (expecting difficult) to successfully achieve multiple objects due to
conflicts and inconsistencies among them. In fact, the Central Bank recognized price stability as a
principle objective, which requires stable macroeconomic condition in the economy. Accordingly, in
2002, Economic and Price Stability designated as the core-objective of the Central Bank. Since the
stability of the financial system is crucial in preventing economic crisis in the country, Financial
Stability was also considered as a core-objective of the Central Bank.

In line with the changes of objectives of the bank, a new organizational structure was established
categorising departments of the bank under the primary objectives or by function groups such as price
stability, financial system stability, agency functions and corporate services. At the same time, several
non-core functions were developed to give priority on core function of the Bank. These changes in the
organizational structure were accompanied by the establishment of advisory technical committees
system to streamline the decision making process in the bank. Accordingly, several committees have
been appointed to advise and recommend to the Monetary Board on monetary policy, financial system
stability

and auditing. The Monetary Policy Committee (MPC) is responsible to recommend on

monetary policy and Financial System Stability Committee (FSSC) is entrusted to recommend on the
regulatory aspects of banking and financial institutions. The Audit Committee (AC) is responsible to
recommend on financial accountancy and risk aspects of the bank. In addition, the Monetary Board
was enhanced by increasing its membership from 3 to 5 which facilitated to accommodate two more
private sector representatives in the Board.
The formulation and conduct of monetary policy also underwent significant changes during the last four
years. The Central Bank has moved

toward market oriented measures in monetary management and

Open Market Operations (OMO) become the principle tool in monetary management in the economy.
In view of the financial sector stability, a series of new measures adopted to improve the liquidity and
strengthen the supervisory and regulatory functions in the bond market. Main policy measures include,
acceptance of treasury bonds for the transactions of secondary window of the Central Bank that help
improve liquidity in the bond market, introduction of new accounting standard and technological
advancement in payment and settlement system in the market. In order to accommodate these reforms,
necessary changes were introduced to the legal framework in the financial system.

The Central Bank has played a vital role as a market maker by designing new debt instruments and
necessary market infrastructure and establishment of effective monitoring and regulatory mechanism
for the development of the bond market. In turn developments in the government bond market have
facilitated the Central Bank to further strengthen the market oriented monetary management strategy.
Because of new policies adopted to create a liquid bond market and consideration of bonds as tradable
instruments at the Central bank windows enabled the monetary authority to use Treasury bonds in the
open market operations (OMO) and manage monetary operations in a more effective manner. Further
development of the domestic bond market would help the monetary authority to conduct the of
monetary management more efficiently in the future.

3.2 Banking System

In Sri Lanka, the banking sector is the systemically most important and dominant sector of the financial
system. The banking sector comprises Licensed Commercial Banks (LCBs) and Licensed Specialized
Banks (LSBs) and representing over 58 per cent of the financial system in terms of the asset base and
94 per cent of the total deposits in the financial system.
There are 23 LCBs operating in the country with an island-wide network with a market share of 81 per
cent of banking sector assets and 48 per cent of entire financial systems assets of the country. In terms
of ownership, 11 domestic banks and 12 foreign banks are in operation in the country. The banking

system is dominated by the performance and financial strength of the 6 largest LCBs, comprising of 2
state banks and 4 largest domestic private commercial banks. These 6 banks are recognized as
Systemically Important Banks (SIBs), accounting for 78 per cent of the LCB sector assets and 65 per
cent of the banking sector assets. In terms of deposits, the SIBs have a market share of 83 per cent of
LCBs and 68 per cent of banking system deposits. Two state owned LCBs continue its dominance in
the banking system having a market share of 37 per cent of assets and 44 per cent of deposits of the
LCBs.

There are 14 LSBs conducting banking business excluding acceptance of demand deposits and dealing
in foreign exchange. Their share in the entire financial systems assets and financial system deposits are
9.5 per cent and 17.2 per cent, respectively. Of this sector, state owned National Savings Bank (NSB)
is the largest LSB accounting for over 50per cent of LSB assets and two large LSBs account for 83 per
cent of assets and 88 per cent of deposits of LSBs. In comparison to LCBs, the businesses of LSBs are
diverse and therefore, risks too are spread out. The systemic importance of the LSBs is less compared to
LCBs. However, the share of LSBs in the financial system is continuously declining over the period due
to rapid expansion of other sectors in the financial system.

3.3

Non Bank Financial Institutions

The market share of the non-bank financial institutions (NBFIs) registered with the Central Bank
comprising Licensed Finance Companies and specialised leasing companies is about 6 per cent of the
financial sector assets. There are 28 NBFIs and 18 specialised leasing companies registered with the
Central Bank and most are private owned institutions. These institutions mobilise funds offering
relatively higher interest rates to depositors who are ready to bear higher risk. Further, lending rates
charged by NBFIs are also high due to high cost of funds as well as to the greater risk associated with
each advances. Mostly these institutions lend for leasing and hire purchase businesses.

The other financial institutions account for 26 per cent of total financial sector assets. The contractual
saving institutions dominate in this sector sharing over 80 per cent in terms of total assets . Employees
Provident Fund (EPF) for which Central Bank plays a custodian role is the largest contractual saving
fund in the country representing 50 per cent of this sector asset base. Other main institutions include
insurance companies, private provident funds, Employees Trust Fund (ETF) and primary dealers.

The financial system plays a multiple role in the bond market operations acting as issuers, investors,
intermediaries and liquidity providers in the market. The primary dealer system (11 primary dealers)
and licensed commercial banks mainly operate as intermediaries in the bond market in addition to
maintaining bonds in their portfolios for trading and investment purposes. In the investment front,

contractual saving institutions which own long term capital are major institutional investors in the
bond market representing over 60 per cent of total outstanding bond stock in the market. The position
available in the financial system for bond holders to undertake discount or repo operations (keep)
improve the liquidity in the bond market.
4) Financial Markets
Financial markets play an important role for the efficient allocation of financial resources and
diversifying risks in the economy. The government has given high priority to develop financial markets
that help lower the cost of raising liquidity and capital. Since financial markets represent a key segment
of the overall financial system, safety and efficiency of financial markets are important to ensure the
stability in the overall financial system.

4.1 Money Market

Money market operations in Sri Lanka comprises two active markets; the first is interbank call
money market and the second is Treasury bill (primary and secondary) market. The other money
market operations such as commercial paper market and central bank securities market are not
significant in the domestic market.
Inter bank call money market is a very vibrant market that facilitates licensed commercial banks to
meet their liquidity mismatches arising from day to day operations thereby matching the liquidity risks
in the banking system. The stability in the liquidity situation in the call market is supported by the
provision of repo and reverse repo facilities through the Central Bank. The borrowing and lending
operations in this market are largely for overnight period. The call market interest rate vary mainly
with the liquidity situations and Central Bank policy rates mostly act as a benchmark to determine the
lending rate in the call market, which is mostly settled in between the two policy rates under normal
market conditions.
Treasury bills which are short term government debt instruments issued under multiple bidding system
used to raise funds from the domestic market for government budgetary operations. Treasury bills are
highly liquid money market instruments and considered as an alternate source of liquidity and
investment vehicle. Under the existing

debt management strategy, new issues of Treasury bills to

raise funds for budgetary operations are limited to a minimum level to reduce the share of short term
public debt stock in the total debt portfolio in order to lower the volatility in the debt market.
However, re-issue or roll-over of existing Treasury bill stock (Rs. 257 billion) through a regular
weekly auction process help maintain the liquidity in the market. The primary market operations are

10

limited only to Primary Dealers (PDs) who are permitted to access to the primary auctions at the
Central Bank through the electronic bidding system. Treasury bill

is the only government debt

instrument permitted the Central Bank to purchase from the primary market. The secondary market
for Treasury bills is very active and covers outright sales and purchases and repo and reverse repo
transactions. With the introduction of scripless form issue under the Scripless Securities Settlement
System (SSSS) complement with Real Time Gross Settlement (RTGS) system and Central Depository
System (CDS), Treasury bill market operations recorded significant improvement in the recent past.
4.2 Equity Market
Sri Lanka has one of the oldest share markets in the world. Share market operations began during the
British colonial period with the inception of Colombo Share Brokers Association in year 1896. Over
the last 110 years period, it has been evolved and since 1990, renamed as Colombo Stock Exchange
(CSE). During last two decades, the CSE has undergone significant changes in order to develop the
activities in the equity market. These developments include establishment of a public trading floor and
inauguration of trading on the open outcry system (1984), liberalization of investment for nonnationals (1990), automation of the clearing system with the establishment of Central Depository
System (1991) and automation of trading with the inception of screen based trading system (1997). As
at end 2006, 238 companies were listed on the CSE and their market capitalization was over Rs. 840
billion equivalent to 32 per cent of estimated GDP for 2006. In several occasions in the recent past, the
CSE was ranked as the most active stock market in the region.

Local investors both individuals and institutions play a dominant role in the equity market in terms of
market value. However, foreign investors, mainly institutional investors played a significant role until
the recent past increasing their share in the market up to 43.3 per cent in 2000. Since then, foreign
investors share showed gradual decline and decrease to below 14 per cent by end of 2005 due to rapid
increase of local participation in the market. Although, this analysis is in terms of a share to the total
market value, foreign investment in value terms has gradually increased over the past. The equity
market

is not fully liberalized for foreign investors as there are some restrictions still

remain

prohibiting or limiting foreign investors entering in to certain sectors of the market.

The equity market comprises 20 sub sectors. In terms of market capitalization, telecom sector
dominates

in the market followed by financial institutions, diversified holdings, hotel services and

food & beverage sector accounting for over 77 per cent of the market. Since the introduction of the
CDS, it acts as the depository for all securities traded and is responsible for the post trade clearing and
settlement of transactions. Trades are in scrip less form that enable to record trading transactions in the
form of book keeping entry by making corresponding debit and credit entries in client accounts. The

11

settlement of the equity market differs for buyers and sellers with T+3 and T+4

settlements dates

system, respectively. In addition, inter-participatory settlement takes place through the nominated
settlement bank of the CDS. In addition to normal trading in the market, stock borrowing and lending
system was introduced in 2001. This is similar to the collateral loans of securities for a limited period of
time under which lender can transfer securities to borrower with an agreement for the borrower to
replace them on agreed time.

The operations of the equity market are highly sensitive to the changes in the political and
peace environment in the country as in most of other markets.

In addition, the market

performance is closely related to the sound fundamentals and profitability of key players in the
market. The financial institutions exposure to the equity market through investment and
lending activities are low and threrefore impact of equity market operations to the financial
system stability is relatively low.
4.3 Bond Market
The bond market in Sri Lanka commenced its active operations in 1990s with the issuance of
medium and long-term bonds, both by the government and the corporate sector. This process has been
accelerated in line with the financial sector reforms and restructuring programme implemented in the
last decade. The debt management policy of the government has substantially reformed by shifting
from issuing non-marketable instruments (such as Rupee loans) and short-term marketable instruments
(such as Treasury bills) to medium and long-term marketable instruments. As a result, the government
compelled to introduce a long-term marketable and fixed income type new debt instrument; Treasury
bond in 1997 to raise funds from the domestic market to finance the government budgetary operations.
Subsequently, government borrowings through non- marketable instruments and short-term marketable
instruments have been gradually reduced over the period. Furthermore, the government has exercised
the early retirement facility or call option of the existing stock of non-marketable securities to replace
them by Treasury bonds to accelerate the development of the bond market. The gradual increase of the
maturity structure of the Treasury bonds enabled the market to establish a medium-term yield curve
which has provided a benchmark for the domestic corporate bond market.

Concomitant to this programme, steps have also been taken to develop the market infrastructure.
These include the improvement of primary and secondary markets, computerisation of market
infrastructure, scrip less form issuing system and improvement of payments and settlements systems.
The required reforms have also been brought into the legal framework, appropriate to the development
of the bond market for the smooth transformation towards the market based debt management. The

12

authority strengthened the monitoring and regulatory work at the central level, in order to ensure the
safety and security of investment made by the public and stability of the overall financial system. The
authoritys continuous commitments on this process and fairly developed domestic money market
operations helped develop the bond market, specially government bond market within a relatively
shorter time period.

Although, a more active market exists for government bonds, the corporate bond market is still at an
under-developed stage. The government has recognized the importance of developing the corporate
bond market to diversify the funding sources in order to reduce the high reliance on the banking system
and the equity market. Further, it would lower the vulnerability of the corporate sector to unforeseen
forces as experienced by some of Asian countries during the Asian Financial Crisis. In this regard, a
number of policy measures have been implemented with a view of developing the corporate bond
market. They include mandatory requirement of credit rating and publication of such rating for all
varieties of debt instruments, registration requirement of all corporate bonds, entrust regulatory
functions of corporate bonds to the Colombo Stock Exchange (CSE) and providing facilities to trade
corporate bonds in the stock market. This development process has to be continued with a welldesigned awareness programme to educate both corporate players and investors about the important
role that could be played by the bond market providing alternative options for investors to invest their
savings and for corporate players to reduce the vulnerability to the system risks by diversifying their
alternative funding sources.
4.4 Foreign Exchange Market
The foreign exchange market which plays an important role in the financial system of redistributing
liquidity within the banking system consists of two main sub sectors; retail or client market and
wholesale or inter-bank market. In Sri Lanka, all Licensed Commercial Banks (LCBs) are registered as
authorized foreign exchange dealers in the country and the inter-bank market operations take place
between LCBs. The transactions in the inter-bank foreign exchange market partly result from the
transaction in the retail market.
In the inter-bank market, transactions occur

on various forms such as spot, tom, cash or forward

basis. Total transactions in this market in value term has been growing over the past and daily average
turnover increased to about US$ 45 million in 2006 in comparison to US$ 30 million in 2005 and US$
18 million in 2004. The spot market continues its domination in the forex market account for over 60
per cent of total operations while forward market, which shows steady growth over the past account for
about 35 per cent of total inter-bank transactions in the market. Although, there are 23 LCBs operate in
the forex market, four major banks account for over 60 per cent of transactions in the market. Increase

13

of international trade and foreign private remittances are main contributory factors for increasing
transactions in the forex market.
Sri Lanka introduced floating exchange rate regime that replaced managed float exchange system
in 2001. The exchange rate i.e. value of Sri Lankan rupee against United States Dollar (USD), is
determined in the inter-bank market through market mechanism. However, since the excessive volatility
in the forex market could have negative impact on the stability in the financial system and the
performance of the economy, the Central Bank intervenes in both sides of the forex market to curb
excessive exchange rate fluctuations. In addition, Central Bank plays a regulator role in the forex
market in order to maintain safe, orderly and stable forex market conditions in the economy.

5. External Debt and Foreign Exchange Reserves

5.1

External Debt

In Sri Lanka, the outstanding external debt consists of Central government debt, public
corporation debt, private sector debt and drawings from the IMF. The external debt, in US dollar terms,
is in an upward trend and increased to US dollar 12,235 million at end 2006. However, total external
debt as a percentage of GDP is in a downward path in the recent past and declined to 43.3 per cent in
2006, from 59 per cent in 2003.

The Central government external debt accounts for over 85 per cent of total external debt. Over
90 per cent of government external debt is concessional debt raised from multilateral (such as IDA,
ADB etc.) and bilateral donors (mainly Japan). A large share of these loans is project loans received for
specific development projects operate under the public investment programme of the government.
However, policy makers maintained a very cautious approach in dealing with international capital
markets. As a result, government or corporation sector have not yet issued foreign currency
denominated international bonds to raise funds from the international capital market.

Of the total external debt, medium and long-term external debt accounts for 94 per cent of the
total outstanding external debt. The central government represents over 85 per cent of medium and long
term external debt while the public corporations and the private sector accounts for balance medium
and long term external debt and the entire short term external debt. The objective of raising medium
and long-term external debt was mainly for the funding of investment activities of the public and
private sectors. The short-term external debt is mainly trade credit facilities, widely used for the
importation of raw materials. Since the countrys capital account is largely closed, private sector is not
permitted to issue rupee denominated corporate bonds to foreign investors or issue foreign currency
denominated corporate bonds in the international market.

14

5.2. Foreign Exchange Reserves

The Central Bank in Sri Lanka has adopted a very cautious approach in managing foreign exchange
reserves in order to stabilize the markets in the unlikely event of an additional foreign currency requests
by the financial system in the economy. Hence, the Central Bank recognized a required floor level of
gross official reserves of the country to be maintained that is equivalent to three months of import cover
of the corresponding year. Since commercial banks also maintain a substantial amount of external
assets, the countrys total external reserves comparatively maintained at fairly high level (around 5
months of import cover) in the recent past. In value terms, gross offered reserves and total reserves of
the country at end 2006 amounted to US$ 2,837 million (covering 3.0 months of imports of goods and
services) and US$ 4,005 million (covering 4.1 months of imports of goods and services).

6. Foreign Direct Investment in the Financial Sector

In Sri Lanka, foreign direct investment in the institutional structure of the financial system are
mainly concentrated in licensed commercial banks (LCBs) and insurance companies while in financial
markets foreign investors participation are almost entirely in the equity market.

In the licensed commercial banks system (23 banks), 12 banks belong to foreign ownership
accounting for 27per cent of the total assets in the banking system. Foreign banks are largely involved
in lending to international trading business and actively operate in the forex market. In the insurance
industry (16 companies), the share of. foreign owned insurance companies operate in the local market
is still low.

Except the equity market, all other financial markets were closed for foreign direct investment due
to restrictions in the capital account operations in the country. However, toward the end of 2006, rupee
denominated Treasury bond market was opened for foreign investors with limited access (5% of total
outstanding bonds). Since the long-term macroeconomic strategy expects to liberalise the capital
market, more foreign direct participants would be expected in the financial system in the future.

15

PART II:

1.

DEVELOPMENT OF THE BOND (GOVERNMENT AND CORPORATE

BOND) MARKET

General Overview
In Sri Lanka, bonds issued in the domestic market could be broadly divided into three types in

terms of the issuers ownership; government bonds, debentures issued by public enterprises and
debentures issued by the corporate sector.
The domestic bond market commenced its active operations only after the issuance of medium and
long term tradable government bonds: Treasury bonds in 1997. It is a product of the new public debt
management strategy envisaged by the government towards the issuance of medium and long term
marketable securities to raise funds for government budgetary operations. The issuance of a marketable,
liquid and long term debt instrument such as Treasury bonds was a long felt need in the domestic
market enabling local investors to match their supply of long-term funds with the demand for long-term
funds from the government. In line with this process, necessary steps have been taken to improve the
market infrastructure and streamline the regulatory framework to enhance the liquidity and efficiency
in the bond market operation. In addition, government has extended series of concessions specially tax
concessions to the participants in the bond market to
investors.

popularize government bonds among local

Although, the corporate bond market is relatively small, the development of government

bond market and establishment of the long term yield curve with liquid secondary market play as
benchmark role and guide the activities of the corporate bond market.

Year
1997
1997
1998
1998
1998
1998
1999
2000
2003
2003
2004
2004
2005
2006

Box 1
Major Developments in the Government Bond Market in Sri Lanka
Event
Issue of Treasury bonds commenced with maturity ranging from 2-4 years.
Permit primary dealers to access to primary auction of Treasury bonds
Accept Treasury bonds for the transaction of secondary window of the Central
Bank
Introduction of electronic bidding system.
Admit Treasury bonds as a liquid asset
Introduction of Jumbo Issues system.
Extend maturity structure of Treasury bonds upto 6 years
Issue of Treasury bonds with Call Option (Later suspended)
Issue of 10, 15 and 20 year Treasury bonds commenced.
Bloomberg Bond trading system for primary dealers was introduced.
Scripless Securities Settlement System (SSS) and Central Depository System
(CDS) for government securities commenced operations.
Operation of the Debt Securities Trading System (DEX) by the Colombo Stock
Exchange(CSE) commenced
Issuance of Index Link Treasury Bond
Opening of Treasury Bond Market for Foreign Investors ( 5% of outstanding bond
stock)

16

A rupee denominated government bond market is represented by Treasury bonds

and

accounted for over 60 per cent (Rs 890 bn or US$ 8.3 bn) of government domestic debt stock at end
2006. Treasury bonds are tradable, medium and long term fixed income securities issued under the
Registered Stock and Securities Ordinance (RSSO) carrying semi-annual coupon (interest) payments.
These bonds are issued under multiple bidding auction basis in scrip less form. The coupon rate is
announced by the Central Bank prior to each auction and the market at the auction in the primary
market determines yield of the bond. Treasury bonds are considered as a liquid asset and opened for
Central Bank window for outright sales and purchases and Repo and Reverse Repo transactions since
1998. The opening of the government Treasury bond market for foreign investors in 2006 could be
considered as a major milestone to improve the competitiveness and expand the investor-base in the
bond market.

In addition, the Central Bank introduced a new foreign currency denominated debt instrument,
called Sri Lanka Development Bonds (SLDBs) in 2001 to finance growing fiscal deficit thereby lower
the pressure on the domestic rupee market. The issues of SLDBs, are made under the Foreign Loan
Act and issues are in scrip form. It is a floating rate bond and the interest rate is linked to LIBOR plus a
competitive margin. However, there is no regular issuing pattern as in the Treasury bond market. Due to
these features, SLDBs are not considered as an active, tradable and liquid debt instrument. The
outstanding SLDB stock as at end 2006 amounted to US$ 580 mn.

In the past, few public enterprises (such as Housing Development Finance Corporation
(HDFC)) have issued debentures to raise funds for their long-term resource requirement and lower their
dependency to

the government budget. However, this process was gradually abandoned in the recent

past and outstanding stock of debentures issued by public enterprises is now at a negligible level. In
addition, Sri Lanka government issued its debut sovereign bonds to international capital market in
2007. The issuance size determined at US$ 500 million to make it bench mark size, in order to get the
highest appetite from the investor comments. The bond has a maturity period of 5 years and a coupon
rate of 8.25%. The bond issue was over subscribed amounted to US$ 1.62 billion and investors
profile shows its attractiveness across the entire global capital markets.
The corporate bond market mainly consists of debentures issued by financial institutions and
few large corporate players in the domestic market. Although, the corporate bond market is relatively
small, recent debenture issues have vast differences in their features such as fixed and variable interest
bonds, unsecured and secured bonds, capital guaranteed bonds, subordinated bonds, convertible bonds
and callable bonds. However, high degree of financial intermediation, a complex issuance process of

17

corporate bonds, lack of proper risk reward structure and high issuance cost specially for small
corporate hinder the issuance of corporate bonds in the domestic market.
2.

Size, Structure and Market Liquidity

2.1 Size of the Market
The persistently high budget deficit, which was largely financed by domestic sources mainly through

Treasury bonds resulted in a rapid growth of outstanding Treasury bonds stock in the recent past.
Accordingly, the size of the Treasury bond market increased from Rs.10 bn (US$ 163 mn) at end 1997
to Rs 896 bn (US$ 8.3 bn) at end 2006. As a ratio of GDP, the Treasury bond stock increased to over
30 per cent in 2006 from below 1 per cent in 1997.

The amount of corporate bonds issued by the corporate sector in comparison to the size of the
government bond stock is at insignificant level. According to the information available at the Colombo
Stock Exchange (CSE), market capitalisation of corporate bonds increased gradually from Rs.0.3 bn
(US$ 5 mn) in 1997 to Rs. 12.5 bn (US$ 120 mn) in 2004. The corporate bond markets share to the
total domestic bond market is less than 2 per cent.

2.2 Issuers Characteristics

In Sri Lanka, the Central Bank on behalf of the government has the sole authority of issuing Treasury
bonds

in the domestic market

while sub-national governments (provincial councils and local

governments) are prohibited to issue debt instruments to raise funds from the domestic market.
According to the present constitutional arrangement for inter-governmental operations, the central
government is responsible for funding the resource gap of sub-national

governments under the gap

filling approach. In addition, resource gap of most of pubic enterprises are also financed by the central
government. Therefore, the central government has to raise funds for its own budgetary operations as
well as to finance other public institutions.

In the past, public financial institutions (such as Housing Development Finance Corporation) issued
debentures to raise long-term funds to provide long-term housing loans. However, such debenture
issues have gradually declined over the recent past and the stock of debentures has declined to an
insignificant level. The corporate bond market, though relatively a small market, has been dominated
by financial institutions and well-reputed large non-financial players in the corporate

sector. The

purpose of issuing bonds by financial institutions was to enable them to reduce their asset/liability
mismatch while other non-financial corporate issued bonds as an alternative resource base to reduce
their reliance on the banking system.

18

2.3. Investors Characteristics

In the government bond market, state sector investors play a major role, accounting for about 70 per
cent of the total bond market.

They include the Employees Provident Fund (EPF), which is a

superannuation fund and the largest fund in the country with the asset base of Rs.492 bn (US$ 4.6 bn)
as at end 2006. This fund has invested over 70 per cent of its total investment portfolio in government
bonds while its total investment on government securities amounted to over 95 per cent of the total
investment.

In addition, National Savings Bank (NSB), which is a government owned savings

institution (Licensed Specialised Bank) with island-wide branch network and deposit base of Rs.225 bn
(US$ 2.2. bn) and Employees Trust Fund (ETF), which is also a superannuation fund with a total asset
base of over Rs.63. bn (US$ 0.6bn), are the other major captive investors in the bond market. In view
of non-captive type investors, insurance companies, privately managed provident funds, commercial
banks and other various funds play an important role. The strategy adopted in the recent past to
popularize government bonds helped diversify the investor base capturing non-bank sector investors
and consequently non-bank sector share in the total bond market increased to 97 per cent at end 2006.
Concomitantly, the private sector share in the bond market too increased accounting for over 30 percent
of non-bank sector investment in the bond market.

The main investors in the corporate bond market are again statutory funds and saving institutions.
These funds are permitted to invest relatively small percentage of their assets on high quality corporate
bonds in the market. Most of corporate bonds are high quality bonds and interest rates offered are
higher than the yields on government securities, making them more attractive among institutional
investors. In addition, such features enable corporate players to attract private investors in to the
corporate bond market.

2.4 Maturity Structure

At the beginning of the government bond market in 1997, the maturity structure of Treasurybonds
had to be limited to 2 years to test the market appetite for medium term

tradable securities.

Subsequently, maturity structure extended up to 6 years. However, the maturity structure of Treasury
bond could not be extended over 6 years until end 2002 due to uncertain fiscal and macroeconomic
environment in the economy. In 2003, government was able to extend the maturity structure up to 20
years with the considerable progress made on both fiscal and macroeconomic management in the
economy. However, this momentum could not be continued in the recent past due to rising inflation
and uncertain peace environment in the country, limiting the maturity structure of new bond issues
below 10 year period.

19

In the corporate bond market, the original maturity period of most bonds are 5 years. However,
the reputed high quality corporate players are able to extend the maturity period of their bond upto 10
years. The existing corporate bond stock has original maturity ranging from 2-10 years.

2.5 Market Liquidity

A critical feature of a well functioning bond market

is a level of market liquidity that gives price

signals and determine the size of the investor-base. In a liquidity market, dealers and other market
participants can buy, sell or maintain a bond portfolio at a price reasonably related to the prevailing
market price. A bondholders ability to sell at a market price at any given movement is a very important
part of an investors decision-making process when determining whether to invest in a particular bond.

Since a liquid and well functioning bond market is a prerequisite to mobilize low cost funds, series
of measures have been taken over the past to enhance the liquidity especially in the government bond
market. Key measures include consolidation of outstanding bond series mainly by introducing reopening process, building liquid bond series in various maturities on a regular basis, develop inter
dealer market, opening of new bond series on a market friendly basis, conduct regular auctions for
different maturities to develop market based yield structure, improve the exit mechanism and
participation of the Central Bank as last resort in order to guarantee liquidity to the bond market. The
effectiveness of these measures in improving the liquidity in the bond market was complemented by the
infrastructure developments in both primary and secondary market. Consequently, a turnover ratio of
the Treasury bond market (the ratio of trading volume excluding repurchase transaction to total
outstanding bond stock) which is an indicator to assess the level of liquidity in the market increased to
1.2 in 2006. However, in comparison to government bond market, market liquidity in the corporate
bond market is very low.
2.6

Primary Market

Treasury bonds are traded through competitive auctions conducted by the Central Bank on a regular
basis. Primary dealers who have been involved in the government debt market since 1992 have direct
access to the primary auctions. According to the present regulatory framework, primary dealers (11
PDs) should subscribe the entire sale and single primary dealer minimum investment level is set at 10
per cent of the volume of sale to avoid any possibility of under subscription. The present auction
system is on multiple price basis. Since 2000, all auctions are conducted electronically using an on line system.

Before each auction, the debt authority accesses the potential investors via primary

dealers to make sure the availability of funds for the full subscriptions. Private placements of Treasury
bonds also take place as a contingency to accommodate unexpected borrowings to avoid market shocks
by offering large volumes to the auctions and cancellation of planned bond auctions. Successful

20

bidders are informed on the same day of the auction and the settlement is two days after the auction
(T+2 system).

Since the establishment of the primary dealer system, the Central Bank continued its role as a debt
manager to develop the primary dealer system. They include streamlining of dealers (removing nonactive dealers, appointing new dealers, etc.), introducing necessary regulatory framework for dealers
and building up close relationship between primary dealers and the Central Bank.

The sales of corporate debentures in the primary market are made mostly through public offerings.
In this trading system, brokers play intermediate role, as there is no appointed primary dealer system for
the corporate bond market.

2.7. Secondary Market

The secondary market operations, which have been developed initially for trading of Treasury bills
were then extended to the trading of Treasury bonds in the market. Today, market intermediaries can
freely transact and intermediate in the secondary market for government bonds. Main participants or
intermediaries in the secondary market are primary dealers, commercial banks, finance companies and
institutional investors. The secondary market transactions of government securities include outright
sales and purchases, Repurchase agreements (Repo) and Reverse Repurchase Agreements (Reverse
Repo).

Mostly thin spread maintained by primary dealers make secondary market operations more
attractive for investors. Further, the introduction of Scrip less Securities Settlement System (SSSS)
could be recognized as major event to enhance secondary market trading, as it help to solve the
problem of time lag, physical delivery and settlement risk. Trading in the secondary market take place
between primary dealers and the Central Bank, among primary dealers and between primary dealers
and other institutions or investors. Over the past, Repo and Reverse Repo market are more active
compared to outright sales and purchases. Although large and wide participation of investors have
contributed to enhance the liquidity situation in the secondary market, dominance of the captive
investors in the market retards the development of the secondary market. In comparison to government
bond market, secondary market operations in the corporate bond market are at marginal level.

In addition, a debt securities trading system (DEX) has been introduced for government securities
for secondary market trading of government bonds in the stock market. DEX trading is scrip less and

21

all transactions are carried out electronically. This DEX facility is also available for corporate bond
listed with the stock exchange.

3.

Bond Market Infrastructure

The priority of developing the bond market is to make sure that market structure including the legal
and regulatory framework, clearing and settlement system and rating agencies are put in place to
support the issue of bonds, investment process and trading activities in the bond market. A welldeveloped and robust market infrastructure is a pre-requisite for the development of an efficient bond
market. A legal and regulatory framework and institutional set up are two fundamental pillars for a
sound debt management system in the economy. In addition, enforcement of rating requirement and
improvement of settlement and clearing systems help improve the attractiveness of the bond market,
protecting both issuers and investors and minimize the default risk.

3.1

Regulatory Framework

A properly designed legal and regulatory framework plays a main role for the sound bond raising
and management in the economy. The laws governing the government local bond market include
Registered Stock and Securities Ordinance (RSSO), Monetary Law Act (MLA) and Annual
Appropriation Act (AAA). The RSSO has empowered the Minister in charge of the subject of Finance
to raise any amount of money by way of issuing Treasury bonds while the MLA has empowered the
Central Bank to act as the agent of the government for the issuance of Treasury bond and management
of public debt. The AAA approved by parliament authorizes the Central Bank to raise the total loans
in or outside Sri Lanka, on behalf of the government, to finance the annual expenditure of the
government. Accordingly, the AAA sets the upper ceiling of the annual bond issues (i.e. gross
borrowing limit) and the MLA authorizes the Central Bank to issue Treasury bonds under the RSSO. In
addition, the law governing the governments issuance of foreign currency denominated bonds {such as
Sri Lanka Development Bonds SLDBs} includes Foreign Loan Act (FLA).

The supervision and enforcement of regulations on the Treasury bond market operations are
exclusively under the authority of the Central Bank. The existing regulatory framework covers the
operations of primary dealers. However, all other players in the secondary market are outside the
current regulatory system. The operational manual issued by the Central Bank to primary dealers
provides guidelines to assess risks involved and is used to assess the soundness of primary dealer
operations.

22

The structure of the public debt management offices, Public Debt Department (PDD) of the Central
Bank has also been reformed in the recent past in order to handle growing complexities in the domestic
debt market in a more efficient manner. Accordingly, functions of the department are broadly divided
into five main divisions; front office (responsible for debt issuance), middle office (handling database
management and research), back office (for servicing of debt), supervision division (supervise PD
operations) and LankaSecure division (which handles SSSS and CDS) as done in most other countries
that have developed debt markets.

The legal and regulatory framework for the prudent operations of corporate bond market includes
the Registrar of Companies Act and regulations issued by SEC and CSE. In addition, Securities and
Exchange Commission (SEC) of Sri Lanka has also issued regulations to permit specialized debt
trading members to use the DEX to trade bonds in the stock market. All corporate bonds are required to
register with the Registrar of Companies and have to be listed at the CSE under the existing regulatory
framework.
Box 2
Directions Issued to Primary Dealers
The Central Bank as the agent of government in public debt management is responsible for the
supervision of primary dealers to ensure an efficient, sound and safe primary dealers system (PDS).
In order to achieve these objectives, the Central Bank has issued directions to primary dealers to
promote their financial soundness and to adopt best practices in trading government securities. Major
directions issued so far are listed below:
Direction on segregation of Proprietary Accounts into Trading and Investment Securities
Account and the Revaluation of Trading Securities at market prices
Direction on Financial statements.
Direction on custodial holding of scrip securities
Direction on Effective Two Way Quotes.
Direction on New Products.
Direction on Establishment of Branches
Direction on Repurchase (Repo) Agreements.
Direction on Capital Adequacy.
Direction on Forward Rate Agreement (FRA) and Interest Rate Swaps (IRSs).
Direction on Firm Two Way Quotes (Bid and offer prices) for Benchmark maturities.
Direction on Accounting for Repo Transactions.
Direction on Minimum Subscription level for Treasury bills and Treasury bonds auctions.
Direction on minimum capital requirement.
Direction on special risk reserve.
Direction on short selling of securities.
Direction on adjusted trading.
Risk management measurement of PDs.
Mark to market valuation of Treasury bills and Treasury bonds
Intra structure Risk Weighted Capital Adequacy Framework
Permit to record customer transactions through cost from CBSL Wide Area Network

23

3.2 Clearing and Settlement System

An efficient and robust clearing and settlement system is vital for the development of the
financial system and also for maintaining financial system stability in the economy. The clearing
and settlement system in the domestic debt market moved to a more advanced payment system; the
Real Time Gross Settlement System (RTGS) in 2003. With the introduction of the RTGS system,
the manual payment and settlement system which was in operations was converted to a computer
based electronic system. Under the RTGS system, transactions become final and irrecoverable
after entries are recorded in the system. Present structure covers all key market participants
namely, the Central Bank, commercial banks, primary dealers, EPF and Central Depository System
of the CSE (total of 34 participants). The RTGS system settles large volume and time critical
payments between direct participating institutions and customer to customer through direct
participating institutions. In addition to operations of bond market, it includes transactions in the
call market, government Treasury bill market, Central Bank open market operations and inter-bank
net clearing.
Since 2004, Central Bank commenced SSS System to facilitate the online settlement of
marketable government securities (both Treasury bonds and Treasury bills). In order to maintain
settlement risk at zero level, Delivery Verses Payment (DVP) System was introduced

for

settlement process by connecting to the RTGS System. The SSS System operates through two-tier
registering mechanism where Central Bank maintain the central registry as the top tier which is
supported by designated sub registries. Meanwhile, sub registries maintain the registers for all nonbank institutions participating in the market.

Box 3
Recent Developments in the Payment and Settlement System
Year

Event

1998

Establishment of Sri Lanka Automated Cleaning House (SLACH)

1994

Introduction of Inter-bank Payment System (SLIPS)

2002
2003

Outsource the functions of SLACH and SLIPS and formed Lanka Clear (Pvt) Ltd. to
undertake functions of inter-bank clearing system.
Introduction of RTGS system

2003

Introduction of Automated General Ledger System (GLS) to the Central Bank

2004

Introduction of Treasury Dealing Room Management System to Central Bank

2004

Introduction of Scrip less Securities Settlement System (SSSS).

2006

Introduction of Lanka Secure system

24

3.3 Local Credit Rating Agencies

Credit rating is an assessment of the creditworthiness of an issue of debt either by a corporate
or a government that help investors to assess the quality of investments. In Sri Lanka, two rating
companies are in operation now. The first rating company, Duff and Phelps Credit Rating Lanka
(DCRL) was established in 1999, and subsequently became Fitch Ratings Lanka (FRL). The FRL
is a joint venture with the Central Bank and other financial institutions. Later, a second rating
company; Lanka Rating Agency (LRA) too commenced its operation in Sri Lanka. The LRA is a
wholly owned subsidiary of Rating Agency of Malaysia Berhad (RAM), which is an affiliate of
Standard and Poors (S& Ps). Both rating companies are recognized by the CBSL to carry out
mandatory rating of organizations, which comes under its purview. Establishment of mandatory
rating requirement would help to improve efficiency, transparency, stability and investor
confidence in the bond market.

In 2003, government made credit rating and publication of such rating mandatory for all deposit
taking institutions and all varieties of debt instruments other than those issued by the government.
The main objective of this policy is to develop the corporate bond market keeping in mind the
safety and security of the investments made by the public. Rating from an independent source
enables the public to assess the risk involved in their investments. This mandatory requirement is
applied to all corporate bond issues exceeding Rs.100 mn. The regulation of rating activities,
including the regulation of rating fees, is entrusted to the SEC.

Since there is no guarantee either from a third party or collateral in the corporate bond market, a
rating company plays an important role in helping investors to evaluate the default risk that helps to
assess the possibility of risk of loss of their investment. Rating of any particular corporate is a
reflection of its credit risk evaluation that improves the awareness of investors to choose bonds in
the market. However, in this process, rating agencies are responsible to provide an effective,
credible and independent credit rating system for the development of the bond market.

In 2005, Sri Lanka too obtained its first sovereign rating from two major international rating
agencies. Fitch Rating assigned BB- for both sovereign long term findings and local currency
rating with positive outlook while S & P assigned B+ for long term foreign currency rating and BBfor long term local currency. However, with the escalation of hostilities in the country resulted in
revising the countrys rating outlook from stable to negative in mid 2006. In 2007, S & P upgraded
the + rating outlook to stable. The government has committed in the medium term macroeconomic

25

program to improve the overall performance in the country thereby upgrading the countrys rating
level.
Box 4
Mandatory Credit Rating Requirement
Type of Institution/Instrument

Expected Date of
Completion
Licensed commercial banks and licensed specialised 01 July 2004
banks
Registered Finance Companies
01 January 2005
Leasing Companies that raise funds by issuing debt 01 January 2005
instruments to the public (only for the above Rs. 100
Mn.)
Private companies that raise funds by issuing debt 01 January 2006
instruments to the public

Current Status
Completed
Completed(accept
2 companies)
Following

Following

4. The Rationale for Developing Domestic Bond Market

In Sri Lanka, the rationale for developing the government Treasury bond market is to develop a
marketable, medium to long term debt instrument to mobilize funds from non bank domestic sources to
finance fiscal deficit and to develop the financial system in the country. Continuation of the persistently
high budget deficit and limited resources available at captive type publicly

managed institutional

investors compelled the government to introduce marketable debt instrument in order to mobilize funds
from non captive type investors in the domestic market. In line with the development of the bond
market, the government expects to create a complete financial system as it helps increase benefit to all
stake holders in the financial market; investors, borrowers and intermediaries.

The development of Treasury bond market helps reduce government reliance on local banking
system and international capital market in mobilizing commercial type borrowings to finance the
resource gap. In turn, it would help to improve risk management in public debt; lowering risks in
relation to interest rate, foreign exchange and refunding exposure, thereby making the economy more
resilient to crisis. In addition, the developed Treasury bond market helps the Central bank for efficient
and effective monetary transmission mechanism and act as a benchmark for the development of the
corporate bond market.

The deficit budgetary policy, which has been adopted by the government since the preindependence in 1948 and persistently high budget deficits prevailed in the last two decades that were
financed largely by market based domestic borrowings resulted in a sharp increase of the accumulation

26

of domestic debt stock. In this fiscal environment, development of the government bond market and the
necessary infrastructure would help ensure the ability of raising long-term funds from domestic nonbank sources and lower the volatility in the domestic debt market. Further, it would help to match the
long-term funding requirement of the government for public investment activities with the long-term
funds available in the domestic investors.

Since the developed bond market is an essential component in a complete financial system, priority
has been given for the improvements in the bond market. The interest rate structure of the welldeveloped bond market reflects the opportunity cost of funds at each maturity level and it is an essential
condition for efficient investment and financing decision-making in the market. In the financial system,
long term funding sources such as superannuation funds, saving institutions show steady growth and the
bond market provide an opportunity to invest such funds. In this process, borrowers, i.e. government
and corporate could lower the reliance on the banking system.

A developed domestic bond market helps to reduce foreign currency denominated commercial
borrowings either from domestic or foreign sources, which could affect the net worth of borrowers
through currency mismatch. When the revenue flow is tied to the local currency, raising funds through
the local bond market provide a natural hedge that make neutral effect to the net worth of borrowers.
The development of the bond market would help to enhance the effectiveness of Central Banks
monetary management in the economy. Since the developed bond market facilitate the government to
raise funds from market sources, the government would be able to eliminate the monetisation of deficit
financing in the budget thereby leaving the Central Bank to conduct its monetary management more
efficiently. The yield curve for developed government bond market mirrors the expectation of likely
macroeconomic development and market reactions to monetary policy moves. Since the Open Market
Operations (OMO) play a key role in monetary policy operations through policy rates (repo and reverse
repo rates), a well functioning bond market would help for the smooth transmission of the monetary
policy in an efficient manner.

At the end 2006, the rupee denominated Treasury bond market was opened for foreign investors
with limited access (5 per cent of total outstanding stock) and able to issue the total volume (Rs. 48
billion) successfully with a maturity range for 2011 years within a short period. The development of the
liquidity and transparency in the bond market would help deepen the Treasury bond market by
attracting more foreign investors in the future. Since the active foreign participation would increase the
competitiveness in the market lowering the interest cost, the development of domestic bond market
would help to strengthen the fiscal strategy, envisage in the medium term macroeconomic programme

27

5.

Challenges and Strategies to well functioning Bond Market

5.1

Factors Hindering Bond Market Development

In Sri Lanka, a slow progress of government Treasury bond market and poor performance of
corporate bond market were mainly due to inadequate encouragements for market participation in the
local bond market. These include issues related to stakeholders; issuers, investors and intermediaries
and infrastructure in the bond market.

In the Treasury bond market, major issues related to issuers consist of lack of systematic auction
schedule in the primary market, high dependency on private placements with captive investors, total
rejections of primary auctions and limited ability to issue bonds in the maturity and amount in
accordance with market needs. In the investors front, domination of publicly managed captive type
funds and institutions, buy and hold policy, restriction on foreign investment, narrow investor base due
to lack of awareness specially in regional centers, and lack of knowledge about trading in the secondary
market could be cited as main issues hindering the development of Treasury bond market. Major issues
related to intermediaries representing primary dealers and licensed commercial banks include limitation
imposed under the dedicated Primary Dealer System (PDS are permitted to operate only in government
securities market single product market), prohibition of short selling and lack of true market makers
participate in the market making process, contributed for low performance in the Treasury bond market.

In addition, issues related to the bond market infrastructure too attributed for slow progress in the
Treasury bond market. Major factors include relatively high transaction cost, taxation issues, lack of
repo agreements, limitations to access to the central clearing and settlement systems, lack of facility to
appoint nominees and inability or limitation to access to the Central Bank window for primary dealers.
All these factors in the market related to participants and infrastructure impacted on the efficiency in
primary market operations and led to under develop secondary market operations.

In the corporate bond market, major factors hindering the corporate bond market operations
include limited number of large corporate players, limited supply of quality bond issues, high rating
cost, disclosure issues specially discouraging family owned companies, high cost of issuing bonds
(interest and other expenses), distorted risk reward system, restriction on foreign investment, absence of
bid- ask price quotation system and lack of awareness among investors. High degree of banking sector
intermediation, providing capital at relatively low cost for prime customers also limited the corporate
sector necessity to issue corporate bonds. In addition, re-investment of retained profit was also a main
funding source in the corporate sector as there was no compulsory requirement to distribute dividends
among shareholders until end 2006.

28

5.2

Past Efforts and Recent Initiatives

Recognising the benefits of developing the bond market, a series of measures and policy initiation
have been introduced to facilitate the activities in the Treasury bond market as well as corporate bond
market. In the Treasury bond market, these measures focussed on the improvement of the attraction of
Treasury bonds, strengthening the intermediary

system, improving the market infrastructure and

deepening the investor base.

In order to improve the attraction of Treasury bonds, several measures were implemented to
improve the liquidity in the bond market. These include the reduction of high fragmentation in the bond
market, introduction of re-opening system for selected on-the-run liquid bonds, extending the yield
curve and introduction of index- link bonds. In addition, considering Treasury bond as a liquid asset in
the portfolio management, and opening of Central Bank window (repo and reverse repo) also helped to
increase attractiveness of Treasury bond market. Introduction of trading of Treasury bonds at the
Colombo Stock Market (DEX operation) would also help improve market.

Since the primary dealers have exclusive rights to participate to the primary auction of the bond
market, several measures were taken to strengthen the primary dealer system. These measures include
the gradual increase of minimum capital requirement, (currently Rs. 300 million) introduction of
dedicated primary dealer system and imposition of risk-weighted capital adequacy (8%) framework. In
addition, a close monitoring system was also introduced for Primary dealers by conducting regular onsite supervision and off-site surveillance in order to ensure the stability of the primary dealer system in
the financial system of the economy. Recent institutions include the PD diversification process which
is expected to be implemented in two stages in 2008.

A well-developed infrastructure system is a pre-requisite for the development of the bond market.
Therefore, more efforts have been taken to improve the clearing and settlement system in the bond
market and strengthen the regulatory framework. Introduction of Scrip less Securities Settlement
System (SSSS), Real Time Gross Settlement System (RTGS), Central Depository System (CDS) and
Delivery Versus Payment (DVP) System were major initiatives to improve the clearing and settlement
system in the bond market. The provision of Intra day Liquidity Facility (ILF) through the Central Bank
and allowing PD to access to the Central Bank repo window was considered as new developments to
improve the liquidity and eliminate the settlement risk in the market.

A narrow investor base due to high concentration on the publicly managed captive sources (Such
as Employees Provident Fund, Employees Trust Fund and National Savings Bank) was a major issues
in the investment front which needed aggressive marketing campaign to diversify the investor base in

29

the bond market. As lack of awareness was recognized as a main reason for low demand from local
investors, the Central Bank and primary dealers, specially targeting regional investors in to the bond
market, have conducted a joint awareness campaign. Specially in 2007, Central Bank has conducted an
aggressive awareness campaign. This programme mainly covered by issuing newspaper advertisements,
printed documents, conducting seminars and media discussions targeting prospective investors. Until
2006, rupee denominated government securities market was restricted for foreign investors.
Recognising the advantages of attracting foreign investment into this market, Treasury bond market was
opened for foreign investors in 2006 with limited access facility.

In the corporate bond market, the government has initiated series of measures to improve the
infrastructure and provided several concessions for investors in order to develop the bond market.
Among them, major initiatives include improvements of the infrastructure in trading bonds in the
market. In addition, a decision taken by the SEC to open a training college to improve the capacity of
market players would help to create an efficient corporate bond market.

5.3

Roadmap for the Development of the Bond Market

The overall strategy towards developing the domestic bond market for the year 2007 and beyond
has to focus on the improvement of the efficiency, liquidity, growth and transparency of the bond
market. In this process, urgent attention need to be given to resolve the existing impediments discussed
earlier. Since the government Treasury bonds dominate in the local bond market, a priority could be
given for the development of Treasury bond market. The developed Treasury bond market would play a
benchmark role and could give a complementary effect for the development of the corporate bond
market.

In designing the Roadmap, more comprehensive approach is required covering all the
components in the bond market; institutions, markets, instruments and infrastructure. Because,
prioritizing the development of one segment of the bond market such as building an efficient
infrastructure would not guarantee the development of the bond market unless other components of the
market too improved in line with the development of the infrastructure. In addition, setting a clear time
frame for the implementation of the policy framework is important for sequencing the policy measures
from short term to long term period.

The efficient implementation of the roadmap for the development of bond market depends on the
macroeconomic environment in the country. Maintaining price stability is a necessary condition to
create a conducive environment for the development of the bond market and improve the perception in

30

the market. In this context, more attention is required to maintain the stability in the fiscal sector as it
has significant impact on the overall macro management that lead to the stability of prices in the
economy. Therefore, governments firm commitment to improve the fiscal operations ensuring the
ability of consolidating the medium term fiscal path would help improve market perception and
actions in the bond market.

5.4

Role of the Central Bank and the Government in Developing the Bond Market

The development of Treasury bond market is primarily a responsibility of the Central bank while
Securities and Exchange Commission (SEC) and Colombo Stock Exchange (CSE) involve in the
development of corporate bond market. However, the government involves in the improvement in the
overall bond market, giving guidance to respective institutions to design the development strategy in
line with the governments medium term macroeconomic policy framework.

The Central Bank has to continue its responsibility in developing the Treasury bond market as the
public debt management function is vested with the Central Bank. Accordingly, the Central Bank can
directly intervene into the functions of Treasury bond market as an issuer deciding issuance (auction)
techniques, bidding pattern, type of bonds, maturity structure, number of series, volume of each series
and time of issuance. A designing of these features with a long term vision is important to improve the
market liquidity, develop the bond market yield curve and efficient price discovery in the bond market.
As a regulator, the Central Bank can strengthen the primary dealers system by appointing suitable
dealers, deciding minimum requirements, regulating primary dealer operations and directing them for
market making process in the bond market. Further, the Central Bank can directly involve in developing
the bond market infrastructure related to improvement of payment and settlement system and set up a
prudent regulatory framework. In addition, the Central Bank can play an advisory role in formulating
the national policy related to the bond market operations focussing further opening of bond market for
foreign investors and taxation of intermediaries and instruments in the bond market in order to maintain
the consistency with the macroeconomic framework that encourage activities in the bond market.
Finally, the Central Bank can lead the awareness campaign and capacity building programme to popular
bonds among investors and improve skills of market operators.

The SEC and the CSE are vested jointly the responsibility of undertaking the main role of the
developments in the corporate bond market. These functions include improvement of the infrastructure
and liquidity in the bond market. In order to maintain the consistency and the level playing field across
bond market, the medium term corporate bond market developments could be designed to follow the
steps taken forward in the Treasury bond market. In addition, these two institutions can advise the

31

government to formulate the national policy framework to create consistent and conducive policy
environment for the development of the corporate bond market.

The government has to play a pivotal role in the overall development of the local bond market. The
capital market development has been one of the key topics in the government policy agenda and a series
of policy measures have been adopted to boost activities in the bond market. The appointment of the
capital cluster; a high level policy body represented by key players in the capital market was a major
event to review the existing issues and advise the government to introduce new policies to develop the
bond market. However, a critical review of the overall bond market in a more coordinated manner is
required to get the maximum benefits out of the development process. In addition, the required changes
need to be introduced to the overall macro policy framework and especially to the financial system in
the country to create a consistent and conducive environment for the development of the bond market.

32

PART III : POLICY IMPLICATIONS FOR BOND MARKET DEVELOPMENT

The future development of the bond market will be determined by the effective and collective
participation of issuers, investors, intermediaries and regulators in the bond market. The effective
participation is in turn depend on the benefit of participation and if benefits are relatively higher and
assured, more participants who are able to participate and willing to participate in the bond market.
Creating an enabling environment around the bond market generating macroeconomic and political
stability and developing a vibrant and stable financial system in the country could facilitate this process.

Since the high cost of finance and limited access to capital are major impediments in investment
promotion in the economy, the development of the bond market has been recognised as a priority area
in the development strategy in the country. The Budget 2007 has indicated that the government has
formulated a 10 year strategy for the promotion of the capital market and other financial innovations to
generate more capital for investment. Further, the Roadmap released by the Central Bank for Monetary
and Financial Sector Policies for 2007 and Beyond has also indicated the commitments for developing
bond market operations in the economy. Accordingly, the CBSL has developed a medium term public
debt management strategy in 2007, covering the bond market developments in the future. In addition,
the SEC and CSE also have indicated their own plans to improve the operations in the corporate bond
market. In line with these programmes, implementation of policy measures listed below would help to
develop a bond market in the economy.

A. Policies to Develop the Bond Market

Develop a Benchmark Yield Curve
Creation of a reliable benchmark yield curve help to develop an efficient bond market.
However, it requires a liberalised interest environment and an active secondary market. Further, it needs
a regular issuance of bonds of various maturities to represent yield rate under each maturity bracket.
Initially maturity structure could be limited for 2 years to 6 years with the plan of gradually increasing
to 10 years in the medium term. New issuances of bonds and reopening of existing bonds need to be
carefully determined in line with the maturity structure of the benchmark yield curve.
Improving Market Liquidity
A market liquidity mirrors in level of an active participation of issuers, investors and
intermediaries and the efficiency of the bond market. A liquid market has diversified trading facilities
for participants according to their choices. Under the present regulatory framework, primary dealers are

33

not permitted for short selling of government securities in the domestic market. These restrictions have
negative impact on the liquidity situation in the market. Considering the advantages of a liquid bond
market, when issue trading facilities and short selling would be introduced to the bond market. In
addition, regular release of two way firm quotes and active e-trading system would help to further
activate the bond market.

Consolidation of Treasury bond Market

A high degree of fragmentation is one of the problems, disturbing the active bond trading in the
secondary market. As at end 2006, there were over 52 Treasury bond series operating in the market.
This has created problems in the trading system as it affects the liquidity of different bonds and
hampers the construction of a price efficient yield curve. Therefore, number of series need to be
gradually reduced to a market friendly level. (below 30 series). The consolidation programme has to be
carefully designed by limiting the issues on new bond while raising new borrowings through existing
bond series by re-opening process.

Buyback Operations
The continuation of excessive borrowings for fiscal operations while reducing the number of
bond series would lead to the threat of bunching, especially daily bunching in the future. Further, heavy
bunching would increase refinance risk (rollover risk). Hence, appropriate measures need to be
introduced to address bunching problem that smoothen out maturity structure of the bond programme.
In this context, more comprehensive approach is required considering the mounting bunching stock and
the capacity of the bond market. Therefore, buyback operations such as switching, exchange, over the
counter purchase and reverse auction techniques need to be gradually introduced to the Treasury bond
market.

Widening the Investor Base

The success of the efficient bond market operations largely depend on the competitive and
wider investor base. At present, investments are more concentrated on captive type institutional
investors and the balance investor base centred on the capital of the country. Therefore, a rigorous
investor awareness campaign needs to be launched to popularise Treasury bonds among regional
investors, both institutional and individual investors. In late 2006, Treasury bond market was opened
for foreign investors with limited and restricted access. An active foreign participation is expected to
help improve competition in the bond market. However, the regulatory restrictions and limited access

34

would lower the efficiency in foreign investors participation Therefore, equal opportunities need to be
offered to foreign investors to get the maximum benefits to the country through the opening process.

Relaxation of Market Operations of Captive Investors

Captive type investors such as Employees Provident Fund (EPF), National Savings Bank
(NSB) and Employees Trust Fund (ETF) largely dominate the investor base of the bond market. These
funds are regulated either by the Central Bank or the government with limited flexibility of access to
the primary market or trading in the secondary market. This has affected the liquidity in the bond
market undermining the development of the market. Therefore, with the improvement of
macroeconomic environment, captive type investors should be permitted to trade in the secondary
market and access to primary market more independently.

Expand the Scope of Primary Dealers

In Sri Lanka, the dedicated primary dealer system was introduced in 2002 under which primary
dealers are permitted to operate only in the government securities market. In addition, number of
primary dealers operating in the market is limited to 11. Since the strength of the primary dealer system
play a vital role in the development of the bond market, diversification of primary dealer activities and
increase of number of primary dealers in the system would help the future development of the bond
market.

Diversifying Bond Instruments

The government bond market is almost a single product market dominated by traditional type
treasury bonds. In developed markets, investors have more opportunities to choose instruments in order
to match their investments. In this regard, one of the new instruments introduced to the bond market is a
index-linked bond. This has to be continued by developing an array of diversified instruments such as
infrastructure bonds, municipal bonds and asset backed securities with proper marketing strategies to
develop the bond market. In this process, the government direct intervention is required to direct the
respective issuing authorities in the public sector.

Develop a Derivative Market

The development of the derivative market helps to lower the uncertainty of risk of return in the
bond market by changing the profile of debt market transactions. The Central bank and the
government can involve in establishing the required infrastructure and start off the activities in

35

the derivative market operations initially through the Treasury bond market. Once the
derivative market is developed, it will spread to the corporate bond market too.
Trading of Government Securities on the Stock Market
Sri Lanka launched the trading of government securities on the Colombo Stock Exchange
(CSE) which is called as DEX Trading from 2003. However, only four members at the stock exchange
currently handle such trading activities. Therefore, intermediary structure need to be improved to
develop the DEX trading activities of government bonds in the stock market in line with the
development of the bond market.

Unification of tax treatments

The present tax treatment gives advantages for investors on government securities while higher
tax liability on the corporate bond market. Since the distorting tax treatment hinders the attractiveness
of corporate bonds in the market necessary changes need to be brought in to the system to maintain the
uniformity in the markets.

Develop Proper Market Structure for Corporate Bonds

A developed and well-established intermediary system is required for an efficient and vibrant
bond market. In Sri Lanka, although government bond market is equipped with a well-developed
intermediary system, lack of such a system is one of the major drawbacks, hindering the market making
process and the development of the corporate bond market. Therefore, the SEC and the CSE can take
necessary policy measures to develop a active intermediary system for the bond market.

Awareness Programmes
Lack of well designed awareness campaign specially targeting prospective investors is also a
reason for the slow progress and the high level of urban concentration of the corporate bond market.
Majority of general public is unaware of the benefit of investing their excess funds in several alternative
sources. As a result, only limited investors largely concentrated in urban centers, could be seen
specially in the corporate bond market Therefore, well designed awareness campaign need to be
launched especially to popular bonds among regional investors.

Measures to Lower cost of bond issues

Under the existing market structure, major corporate players are in a more advantaged position
to access alternative financing sources and raise funds from the banking system at a relatively lower
interest rate (prime lending rate) which is close to the interest rate in the government securities market.
As an issue of corporate bonds requires number of pre-conditions to be fulfilled such as rating

36

requirement, market arrangements, publicity, etc., at the issuers expense, total effective cost of issuing
bonds is higher than the cost of borrowings from the banking system, specially for prime customers in
the banking system. This has discouraged the issuers of corporate bonds in the domestic market.
Considering the important of developing this market, necessary steps to be taken to lower the overall
cost structure of the issuance process.

Streamline trading on the DEX market

The extension of the trading of bonds in the stock market would help to trade government
securities in a more efficient manner. However, the recently developed SSSS for the government
securities market is not yet connected to Colombo Stock Market, delaying trading activities of bonds.
Therefore, providing direct access facility to the SSSS for CSE would help improve the operations in
the bond market.

Development of Unit Trusts

In order to bring small savers/investors in to the bond market, high priority need to be
given for the development of unit trusts to mobilize deposits from small savers and invest in
the bond market. During the initial stage, some concessions need to be granted to Unit Trusts
to encourage the development of Unit Trust System in the country.

B. General Issues

Improve macroeconomic environment

One of the pre-conditions required for the development of the bond market, specially the
corporate bond market,

is the investors and issuers confidence on long term stability in the

macroeconomic environment. In Sri Lanka, the ethnic conflict that prevailed in the last two decades
and political instability in the recent past have created an uncertain socio economic environment.

In

addition, persistently high budget deficit pre-empt the resource available mostly with long term
investors in the market. This situation had also contributed for the slow progress in the bond market.
Impact of fiscal operations and overall macroeconomic management as envisaged in the medium term
strategy would help the bond market development in the economy.

VI. Conclusions

The bond market in Sri Lanka shows an imbalanced development, more developments
in the government bond market and slow progress of the corporate bond market.

37

The

continuation of the deficit budget policy, which requires funds largely from the domestic
market, compelled the authorities to develop the government bond market. The Central Bank
plays a vital role in developing the government bond market. This process includes the
development of debt instruments, intermediary system, legal and regulatory system and
improvement of payment and settlement system. Further, extension of bond trading to the
stock market helps further development of liquidity in the bond market. This development
helped to raise funds at a lower cost while providing investors a market based investment
environment. In the corporate bond market, relatively small corporate sector, high cost of
issuing bond under complex mechanism and limited investors coupled with the availability of
funds from alternative sources at a rate closer to interest of government securities could be
cited as main factors that prevented the development of the corporate bond market.

There is number of market constraints as well as legal and regulatory constraints that prevented
achieving the full benefit to both issuers and investors as well as to the economy. As discussed before,
these issues have to be corrected gradually without disturbing the existing operations in the market.
Majority of market players are still unaware of the advantages of developing the bond market to
minimise risk in the financial system. Therefore, further development of the bond market need to be
accompanied with the well designed awareness comparing to get the maximum benefit to all the stake
holders in the future.

38

References
1) Central Bank of Sri Lanka : Annual Reports of several years.
2) Central Bank of Sri Lanka : Financial System Stability Review: 2004 2006
3) Central Bank of Sri Lanka : Financial System Stability Pamphlet Series No. 2: October 2005
4) Central Bank of Sri Lanka :Public Debt Management and Debt Profile of Sri Lanka: 2004.
5) Central Bank of Sri Lanka: Roadmap : Monetary and Fiscal Sector Policies for 2007 and
Beyond, 2007
6) Department of National Budget : MT Budgetary Framework 2006 2009 , Ministry of Finance.
7) Dalla, Ismail: Harmonisation Bond Market Rules and Regulations in Selected APEC
Economics, Asian Development Bank, 2003
8) World Bank and IMF : Developing Government Bond Markets: A Handbook, Washington DC,
2001.
9) Colombo Stock Exchange : Fact Books: Various Issues,
10) Harwood Alison: Building Local Bond Markets, An Asian Perspective, International Finance
Corporation, 1999.
11) Kubmiarso Banbang: The Development of Domestic Bond Market and Its Implication to
Central Banks; Countries Experiences, 2005
12) Ministry of Finance: Budget Speeches of several years
13) Pace, Guilia and Trimpath, Susanne: Bond Market Development in Selected Asian Countries,
Milken Institute Working Paper No11, 2003
14) Securities and Exchange Commission of Sri Lanka Annual Reports of several years
15) Siriwardena, C.J.P: Development of Domestic Bond Market and Its Implication of the Central
Bank : The Core Functions, SEACEN Centre, Kuala Lumpur, Malaysia, 2005
18) Tadashi Eudo: The Development of Corporate Bond Markets, International Financial
Corporation, 2000

39

Appendix Tables
Table 1:Key Economic Indicators in Sri Lanka
Item

Unit

2000

2005

2006

Projection
2008
2009
7.5
8.2

2010
8.5

GDP Growth

6.0

6.2

7.7

2007
6.7

National Savings

%GDP

21.5

23.7

23.48

23.7

26.1

28.6

29.9

Investment

%GDP

28.0

26.5

28.7

29.5

31.0

32.5

33.0

Unemployment

7.6

7.7

6.5

6.3

6. 0

5.5

5.0

GDP deflator

6.7

10.0

10.3

12.9

9.5

8.5

7.0

Overall budget deficit

%GDP

9.9

8.4

8.1

7.2

7.0

6.0

5.4

Public Debt/GDP

96.9

91.1

89.2

85.5

82.3

77.6

73.0

Overall /BOP

US$ Mn.

-522

501

204

450

301

349

403

Current Account Deficit

Of BOP

%GDP

6.4

2.7

4.8

4.3

4.1

3.8

3.4

Broad Money Growth (M2b)

12.9

19.1

17.8

19.0

16.5

16.0

15.0

Source: Ministry of Finance

Central Bank of Sri Lanka
Table 2: Financial Market (as at mid 2006)
Assets
Financial Institution

Rs. Bn.

Central Bank of Sri Lanka

Institutions Regulated by the CBSL
Deposit Taking Institutions
Licensed Commercial Banks
Licens Licensed Specialised Banks
Regist Licensed Finance Companies
Other Institutions
EeEmployees' Provident Fund
PrPrimary Dealers
SpSpecialised Leasing companies

Deposits

Share

Rs. Bn.

Share

473.9

13.7

na

na

2,643.4

76.4

1,355.5

97.9

2,073.2

59.9

1,355.5

97.9

1647

48

1066

77

329.9

9.5

237.8

17.2

96.4

2.8

51.8

3.7

570.2

16.5

na

na

455.0

13.1

na

na

46.7

1.3

na

na

68.5

2.0

na

na

343.7

9.9

29.0

2.1

32.0

0.9

29

2.1

26.8

0.8

24.2

1.7

5.2

0.2

4.8

0.3

280.2

8.1

na

na

Employees Trust Fund

62.5

1.8

na

na

Private Provident Funds

107.5

3.1

na

na

Insurance Companies

110.2

3.2

na

na

31.5

0.9

na

na

Institutions not Regulated by the CBSL

Deposit Taking Institutions
Rural Banks
Thrift and Credit Co-operative
Societies
Contractual Savings Institutions

Other Specilised Financial Institutions

Merchant Banks

25.3

0.7

na

na

Venture Capital Companies

1.5

0.0

na

na

Unit Trusts

4.7

0.1

na

na

3,461.0

100.0

1,384.5

40.0

Total Assets

40

Table 3
Government Domestic Debt (Rs. Million)
Type
Marketable
T. bills

1996
1997
1998
1999
2000
2001
124,996 124,996 168,911 229,863 339,120 400,170
124,996 114,996 119,996 124,996 134,996 170,996

2002
558,124
210,996

2003
702,402
219,295

2004
887,235
243,886

2005
2006
985,743 1,143,704
234,174 257,732

48,915 104,867 204,124 229,174

347,128

483,107

643,349

751,569

885,972

Non-Marketable 231,707 262,744 294,515 313,601 337,540 415,795

508,216

317,566

256,154

279,978

331,816

T. bonds

Total
Share of
marketable to
total %

10,000

356,703 387,740 463,426 543,464 676,660 815,965 1,066,340 1,019,968 1,143,384 1,265,721 1,475,520

35

32

36

42

50

49

52

69

78

78

T-bills are up to 1 year maturity while T-bonds are over 2 years Maturity
Source: Central Bank of Sri Lanka

Table 4:Treasury Bond Issues (Rs. million)

Maturity
(Yrs)
2

1997
7,500

1998
25,065

1999
11,000

2000
58,321

2001
21,422

2002
27,566

2006

3
4

1,000
1,500

9,450
4,400

26,448
18,904

27,951
10,000

77,810
19,221

19,534
-

5
6

6,000
1,000

14,550
14,550

45,170
43,500

7
8

38,915

63,352

125,372

39,723

49,900
8,100

104,187
19,348

109,566
53,316

43,700
68,000

22,900
2,000

12,659
-

57,397
8,980

3,625

7,865
-

3,625

33,950

10,000

2005
89,731

20,250
35,600

9
10
13
15
20
Total

2003 2004
3,000 124,298

10,000
-

4,397
4,900
1,000
207,123
47,100 214,797 217,198 229,550
Source: Central Bank of Sri Lanka

41

276,847

78

Table 5:
Investor Base
1. Bank Sector

1997

Investors Base of Treasury Bonds (Rs. Mn.)

1998

1999

2000

2001

2002

2004

2003

1,788

5,808

8,405

38,648

22,214

35,523

65,246

452

30,936

1,616

1,788

5,808

7,953

7,712

20,598

35,523

65,246

8,212

43,107

3,100

2.2 Other Provident Funds

1.1 Central Bank

2005

33,350 55,118

2006
25,680

33,350

55,118

25,680

96,462 165,476 206,960

311,605 417,861 609,999

696,451

860,292

11,912

27,635

50,003

64,758

109,093 187,665 283,428

344,830

408,756

83

147

449

591

287

240

2.3 Savings Institutions

2.4 Insurance & Finance
Companies
2.5 Departmental & other
official funds

1,609

10,372

20,656

25,472

28,964

42,292

54,449

92,227

104,235

112,062

1,876

6,849

7,987

10,940

16,258

21,159

20,740

26,551

8,214

13,690

65

571

907

13,176

16,061

17,010

17,375

23,641

34,922

52,719

2.6 Private & Other

1,562

13,320

39,130

65,436

80,919

121,460 137,294 183,912

204,251

273,065

10,000

48,915

751,569

885,972

1.2 Commercial Banks

2. Non Bank Sector
2.1 Employee Provident Fund

3. Total

104,867 204,124 229,174

347,128 483,107 643,349

Source: Central Bank of Sri Lanka

Table 6:
Type
Outright
Sales
Purchases
Repurchases
Repo
Reverse Repo
Total
Repurchase to Outstanding Bond
Stock (%)
Total operations to Outstanding
Bond stock (%)

Treasury Bonds Secondary Market Operations (Rs. billion)

1999
86
59
27
0
0
0

2000
202
128
74
1,083
756
327

2001
74
49
25
859
482
377

2002
294
186
108
1,232
1,006
226

2003
777
427
350
2,244
1,939
305

2004
395
222
173
2,792
1,984
808

2005
291
163
128
2,134
1,066
1,068

2006
292
165
127
1,707
1,069
638

86

1,285

933

1,526

3,021

3,187

2,425

1,999

531

375

538

464

434

284

196

82

630

407

666

625

495

323

230

Source: Central Bank of Sri Lanka

42

Table 7; Financial Sector Profile (Rs. billion)

Item
Domestic credit

1996
202.4

2006
1997
1998
1999 2000 2001
2002
2003
2004
2005
1,255.7
230.2 381.9 427.7 475.5 515.3 568.7 664.5 809.5 985.4

by Financial sector
Stock market
Capitalisation

104.2

129.4

116.7

112.8 88.8

124

162.6

262.8

382.0

584.0

834.8

Govt. Bonds

10

48.9

104.9 204.1

229.2

347.1

483.1

643.3

751.6

886.0

Corporate bonds

0.3

3.2

7.3

10.3

9.7

12.4

n.a

306.6

369.9

508.3

Total

4.6

5.8

612 744.4

n.a

872 1093.2 1406.8 1646.2 2,320.0 2,976.5

Source: Central Bank of Sri Lanka

(a) Include Licenced Commercial Banks, Licensed Specialised

Banks and Finance Companies (M4)

Table 8:Issue of Corporate Bonds

1997
No. of Issues
No. of Issuers
Amount Raised (Rs.
million.)

1
1
885

1998
11
6
2,668

1999
7
5
1,743

2000
8
4
2,056

2001
7
3
1,539

2002
12
5
2,979

2003
2
1
2,244

2004
14
4
3163

2005
8
2
350

2006
7
2
2,257

Source :Colombo Stock Exchange

Table 9;Trading of Corporate Bonds in the Colombo Stock Market (Rs. million)
1997
1998
1999
2000
2001
2002
2003

2004

2005

Turnover (Rs. Mn)

57.2

320.8

550.6

425.3

151.9

340.7

180.2

199.5

206.8

No. of Trades

203

1,688

2,461

1,70.1

1,096

2,445

1,685

136.2

625

No.of Debentures Traded

(Mn)
Market Capitalisation (Rs.
Mn)

0.6

4.2

8.3

25.1

9.1

17.6

2.7

2.2

2.2

329

3,191

4,584

5,803

7,323

10,300

9,671

12,471

Source : Colombo Stock Exchange

43

44