The Impact of COVID-19 on Financial Markets and A Closer Look at Sri Lanka

May 29, 2020        Reading Time: 7 minutes

Reading Time: 7 min read


Image Credits: Markus Spiske/Unsplash

*Angela Huettemann

The spread of COVID-19 has kept investors around the world in suspense since February, when financial markets started their slide. Since then, markets have been subject to high levels of volatility, divestments, and flight into ‘safer haven assets’.1 Political leaders have titled the spread of COVID-19 the ‘biggest challenge since World War II’, while the IMF forecasts the ‘great lockdown’ as the ‘worst economic downturn since the great depression’. This Blog will look more closely at financial market responses to the spread of COVID-19, paying special attention to Emerging Markets and Sri Lanka.2 This Blog further assesses potential ways on how to bolster domestic and foreign investor sentiment in the Sri Lankan stock market in the short- and longer-term.

Developed Markets

Uncertainty and worries over a prolonged global economic downturn following the global spread of COVID-19 and the subsequent lockdown of countries have triggered a synchronised sell-off in equities and commodities in February and March 2020. Stock markets of advanced economies recorded their worst losses since the financial crisis in 2008, with many of them entering bear market territory (indicated by a more than 20% slump in index values). The fall in equities was further exacerbated by plunging oil prices, which sparked additional fears over a looming global economic downturn. The MSCI World Index, which reflects stock market movements of 23 developed economies, fell by more than 34% from peak to trough in little more than a month, down to its lowest level since July 2016. (Figure 1).

An indicator of risk sentiment and heightened uncertainty, Chicago’s Board Options Exchange Volatility Index rose to its highest ever recorded level in history on 20th March.3 In a ‘flight to quality’, assets such as Gold and the US Dollar recorded new highs, after a temporary fall at the beginning of March.4 What’s more, bond yields fell (indicating that prices rose), highlighting investors’ preference for perceived ‘safer haven assets’.

Governments and Central Banks reacted quickly to the market turmoil and launched manifold support programmes for businesses, households, and the financial system. Various Central Banks, including the Federal Reserve and Bank of England, cut policy interest rates and started bond purchasing programmes, providing additional liquidity for the financial system. Following the wide-ranging stimuli, markets have started recouping parts of their losses since the end of March. More recently, heightened hopes over encouraging signs of a potential COVID-19 vaccine from Japan and statements by Federal Reserve Chair Jerome Powell on the possibility of further easing measures provided an additional boost to the market.5 Whether or not the bear market will be short-lived, or a longer-term reality will depend on a combination of various factors, such as the geographic spread of Coronavirus, development of case numbers, the duration of the lockdown, and respective stimulus measures employed.

Figure 1: COVID-19 Spread and Development of Global Financial Markets6

 Note: LKI calculations based on Morgan Stanley Index Data 2020. Information as at 21 May 2020.

Emerging Markets

Emerging Markets face additional challenges with regards to containing the pandemic and its impact on society and economy against limited fiscal scope to implement fiscal stimulus, more fragile health systems and less developed social safety nets. What’s more, the fall in commodity prices such as oil and copper, which exporting countries such as Nigeria, Chile, and Brazil depend on, mean a significant loss in foreign exchange earnings to bolster local exchange rates.7 Further, countries such as Bangladesh and Mexico, are affected by impeded global supply chains. Turkey, Thailand, the Maldives, and Sri Lanka suffer from a fall in tourism, also putting a strain on exchange earnings.8

Reflective of this, investor preferences have shifted towards safer haven assets, which has been felt dearly by emerging economies. According to Bloomberg, more than 25% of local currency debt is owned by foreigners in Emerging Markets, increasing vulnerability to capital flight.9 In March alone, an estimated total of US$ 83 billion capital10 has been withdrawn from Emerging Markets, more than during any month of the financial crisis.11 The flight of capital increases pressure on Emerging Market economies, as it limits government interventions and weighs on the local currency. Many economies, such as Mexico, South Africa, and Indonesia, have seen their currencies depreciate during the spread of COVID-19, increasing costs of foreign-currency-denominated debt repayments, further fuelling investor concerns. In reverse, the Dollar Index has climbed to new highs in March.

Against these challenges, the MSCI Emerging Markets Index fell by 31% between 19th February and 23rd March. Ever since, investor sentiment has improved slightly, providing tailwind to the market’s recovery. (Figure 1).

Sri Lanka’s Market

The spread of COVID-19 puts additional strain on Sri Lanka, a small open economy with limited fiscal scope to combat the pandemic. That said, the government has employed wide-ranging measures to curb the spread, and cushion the impact on businesses and people, aided by multilateral agencies and support from China, the United States, the EU, Canada, and India.

Similar to other emerging economies, worries over an economic slowdown in Sri Lanka, led to a sell-off in the financial market and capital outflows. In less than two months12 the country witnessed a 70% outflow of foreign-owned T-bills and T-bonds (US$ 372 million or 0.42% of GDP)13 , whilst the Sri Lankan Rupee depreciated by 5.3% over the same time frame.14 The CSEALL Price Index, Sri Lanka’s leading stock market index, fell to its lowest level in eight years on 12th May. Previously, trading had been suspended to restrict panic selling. Ever since, the market has increased 13.1%, leading to a Year-To-Date return of -21.6%.15

As with global financial markets, the recovery of Sri Lanka’s stock market is directly linked with the business environment and will depend on a variety of factors, such as the duration of lockdowns, the success of stimulus measures, as well as investor, business and consumer sentiment. These factors will largely determine if COVID-19 will lead to 1) a shorter-term economic slow-down with economic recovery setting in once Sri Lanka eases out of lockdown, triggering a relaxation of Sri Lanka’s stock market or 2) longer-term subdued economic growth, with the financial market staying in bear territory for a prolonged period of time.

Opportunities for the Development of Sri Lanka’s Stock Market

Fast-tracking the recovery of Sri Lanka’s stock market yields an important opportunity to mobilise additional foreign as well as local capital, which provides an important source of funding for local companies to recover from the pandemic.

In the short-term, the Sri Lankan government has the potential to provide additional support for businesses to help cushion the impact of COVID-19 on their operations. A recent poll of 200 Sri Lankan CEOs revealed that supportive measures such as the debt moratorium for interest and capital payments as well as selective low cost working capital financing should be extended to all economic sectors to alleviate financial pressures on businesses.16 Further, the government should seek to support the Sri Lankan Stock Exchange17 in requesting listed companies to provide disclosure of COVID-19 impact on their current and future business operations. Making public the impact of the virus on their business operations and any counter measures which have been employed are of material importance for investment decisions.

Longer-term, the Sri Lankan government has the potential to drive stock market development, by lifting size and liquidity constraints of the Sri Lankan stock market. In comparison to regional peers, Sri Lanka’s market is small in size and less liquid, both important investor criteria which keep large institutional or foreign investors at bay. As such, listing key privately-owned and state-owned enterprises would expand the size of the stock market and increase investor interest. To increase liquidity, pension reforms should allow professional portfolio managers to manage pension funds (such as EPF and ETF) to offer a more diversified basket of investment opportunities, tailored to investor’s risk appetite and preferences. The associated surge in demand for equities and securities will in turn increase market liquidity.18 Further, targeted promotional campaigns such as the 2015 ‘Invest in Sri Lanka’ forum will help raise international awareness and investor interest in Sri Lanka’s stock market. The domestic stock market provides diversification benefits for investors, as it has historically shared a low correlation with other major markets such as the US.19 It offers a comparatively low P/E ratio to other emerging economies and thus an attractively-priced entry point for investors searching to diversify their portfolio. These features need to be marketed to domestic and international investors.

Ultimately, the above efforts need to be complemented by a national financial market development plan, which encompasses commitment from all key parties such as the Colombo Stock Exchange, Central Bank of Sri Lanka, Securities and Exchange Commission, and the Ministry of Finance. Structural and policy reforms are required to establish an effective financial system with a more broad-based financial market.

COVID-19 is likely to reinforce trends which have established themselves in the past. As such, it presents an excellent opportunity to revisit underlying issues of Sri Lanka’s stock market, which keep investors at bay, and may provide additional momentum for necessary stock market reforms.

Notes

1Assets, which are believed to retain or increase in value during turbulent times and therefore limit investor exposure to losses in case of a market downturn.

2Gopinath, G. (2020). The Great Lockdown: Worst Economic Downturn Since the Great Depression. IMF Blog [Online]. Available at: https://blogs.imf.org/2020/04/14/the-great-lockdown-worst-economic-downturn-since-the-great-depression/ [Accessed 22 April 2020]; Petzinger, J. (2020). Germany’s Merkel says COVID-19 is the ‘biggest challenge since WWII’ in rare national address. Yahoo!Finance. [Online] Available at: https://uk.finance.yahoo.com/news/merkel-calls-covid-19-the-biggest-challenge-since-wwii-in-rare-tv-address-to-germany-184926108.html [Accessed 22 April 2020].

3Bloomberg. (2020). VIX:IND – Chicago Board Options Exchange Volatility Index. [Online] Available at:
https://www.bloomberg.com/quote/VIX:IND [Accessed 20 April 2020]; Li, Y. (2020). Wall Street’s fear gauge closes at highest level ever, surpassing even financial crisis peak. CNBC. [Online] Available at: https://www.cnbc.com/2020/03/16/wall-streets-fear-gauge-hits-highest-level-ever.html
[Accessed 20 April 2020].

4Bloomberg. (2020). DXY:CUR – Dollar Index Spot. [Online] Available at: https://www.bloomberg.com/quote/DXY:CUR [Accessed 24 April 2020]; Bloomberg. (2020). XAU:CUR – Gold Spot $/Oz. [Online] Available at: https://www.bloomberg.com/quote/XAU:CUR
[Accessed 20 April 2020].

5The Guardian. (2020). Markets surge amid Covid-19 vaccine hopes and Fed’s stimulus pledge – as it happened. [Online] Available at: https://www.theguardian.com/business/live/2020/may/18/markets-rally-federal-reserve-powell-vaccine-japan-recession-ftse-business-live [Accessed 22 May 2020].

6Morgan Stanley Index Data. (2020). End of Day History – Data. [Online] Available at: https://www.msci.com/end-of-day-history?chart=regional&priceLevel=0&scope=R&style=C&asOf=Mar%2030,%202020&currency=15&size=36&indexId=106 [Accessed 16 April 2020].

7Walker, A. (2020). Developing world economies hit hard by coronavirus. [Online] BBC. Available at: https://www.bbc.com/news/business-52352395 [Accessed 30 April 2020].

8Hecking, C. (2020). Kapitalflucht aus Schwellenländern stärker als zur Weltfinanzkrise 2008. [Online] Spiegel. Available at: https://www.spiegel.de/wirtschaft/soziales/corona-krise-kapitalflucht-aus-schwellenlaendern-staerker-als-zur-weltfinanzkrise-2008-a-42132876-7473-4dba-94de-5306e8a60809 [Accessed 30 April 2020].

9Ashworth, M. (2020). Emerging Markets are Peering Over the Precipice. [Online] Bloomberg Opinion. Available at:
https://www.bloomberg.com/opinion/articles/2020-04-07/coronavirus-emerging-markets-are-peering-over-the-precipice [Accessed 20 April 2020].

10Fortun, J. & Hilgenstock, B. (2020). IIF Capital Flows Tracker – April 2020 – The COVID-19 cliff. Institute of International Finance. [Online] Available at: https://www.iif.com/Portals/0/Files/content/1_IIF_Capital%20Flows%20Tracker_April.pdf
[Accessed 23 April 2020].

11US$53 billion in bonds, US$30 billion in equities.

12Central Bank of Sri Lanka. (2020). Weekly Economic Indicators – 17th April 2020. [Online] Available at:
https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/statistics/wei/WEI_20200417_e.pdf [Accessed 20 April 2020]; Central Bank of Sri Lanka. (2020). Weekly Economic Indicators – 20th February 2020.  [Online] Available at: https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/statistics/wei/WEI_20_02_2020_E.pdf [Accessed 20 April 2020].

13Between 19th February and 15th April.

14Bloomberg. LKR:CUR – Sri Lankan Rupee Spot. [Online] Available at: https://www.bloomberg.com/quote/LKR:CUR [Accessed 20 April 2020].

15Bloomberg. CSEALL:IND – CSE ALL INDEX. [Online] Available at: https://www.bloomberg.com/quote/CSEALL:IND [Accessed 22 May 2020].

16Daily Financial Times. (2020). Top CEOs share wish-list for how SL can emerge stronger post-COVID-19. [Online] Available at: http://www.ft.lk/top-story/Top-CEOs-share-wish-list-for-how-SL-can-emerge-stronger-post-COVID-19/26-699092 [Accessed 23 April 2020].

17Daily Financial Times. (2020). CSE requests listed firms to disclose COVID-19 impact. [Online] Available at: http://www.ft.lk/front-page/CSE-requests-listed-firms-to-disclose-COVID-19-impact/44-699043 [Accessed 24 April 2020].

18Samarakoon, L. (2016). Sri Lanka Capital Market Assessment. Asian Development Bank. [Online] Available at: https://www.adb.org/sites/default/files/project-document/202066/49365-002-tacr-01.pdf [Accessed 24 April 2020].

19Preis, R. (2019). Sri Lanka’s Market: An Investment Gem Hidden In Too Much Pessimism. Forbes. [Online] Available at: https://www.forbes.com/sites/rainermichaelpreiss/2019/08/07/sri-lankas-market-an-investment-gem-hidden-in-too-much-pessimism/#19a167255df6 [Accessed 22 April 2020].


*Angela Huettemann is a Research Fellow at the Lakshman Kadirgamar Institute of International Relations and Strategic Studies (LKI) in Colombo. The information in this blog is as at 22nd May 2020. The opinions expressed in this article are the author’s own views. They are not the institutional views of LKI, and do not necessarily represent or reflect the position of any other institution or individual with which the author is affiliated.

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