Fast-disappearing treasuries the pick in Sri Lanka

COLOMBO (Reuters) - When Sri Lanka's 25-year civil war ended last year, investors surged to its share market and sent the index rocketing up 125 percent and making it the top pick in global frontier investments.

So far this year, stocks are up around 25 percent, making it Asia's top gainer, but Sri Lankan government securities have emerged as the hotter investment in the Indian Ocean country.

"The bond market is more liquid and foreign investors can buy large volumes," said Channa Amaratunge, director at CT Capital.

"The valuation and price-to-earnings ratio compared to other markets also have had an impact on foreign investments in shares," Amaratunge added.

The price-to-earnings multiple of Sri Lankan stocks now is at more than 20, compared to around 11 in 2009. Analysts say the figure is not supported by fundamentals, but rather local speculators buying up shares.

The benchmark 91-day treasury bill yielded 8.13 percent at an auction on May 19. In addition, the rupee currency is seen likely to be firm or even appreciate slightly.

"We expect the rupee to have gradual appreciation into the end of the year," said Garvin Van Dort, head of trading at HSBC Sri Lanka. He targets the 113.00/25 range by year's end from current levels of about 113.75/80.

"If we see more inflows of foreign direct investment or inflows into the stock market, then obviously there could be a case for a more aggressive appreciation," he said.

Besides the end of the war, another positive factor for investors came into place last month when President Mahinda Rajapaksa's ruling coalition won a resounding majority in parliament three months after his own landslide re-election.

The stability the end of the political season brought has re-ignited the debt market, which had already enticed foreign investors after the country's sovereign rating was raised last year and it secured a $2.6 billion IMF loan.

However, government regulations that cap foreign investment at 10 percent of all outstanding treasury securities are proving a stumbling block.

"The bond market has picked up quite a bit from pre-election. It's just that because we are at or close to the cap, there is not much available to meet that demand. That is actually the only reason we are not seeing more funds flowing in," Van Dort said.

According to the central bank, only about $100 million remains of the $1.9 billion available to foreign investors.

On the other hand, analysts and traders say the small Colombo Stock Exchange, with a market capitalization of about $11 billion, still suffers from a lack of free float and high volatility that makes it less attractive to foreign investment.

Foreign investors have sold a net 16.8 billion rupees ($147.8 million) worth of shares this year against net selling of 789 million rupees last year, suggesting most were locking in profits after correctly predicting the post-war boom.

NO RAISING CAP

Even though investors are keen for more treasury securities, the government says it has as no plans to raise the foreign holdings cap.

"From our debt market, what we want is to ensure the proper safeguards for the country's overall macroeconomic environment. How much exposure can the country withstand?" P.B. Jayasundera, secretary to the treasury and finance ministry, told Reuters.

Any appreciation in the rupee could hurt exports, which made up 17 percent of the country's GDP in 2009. However, the $42 billion economy imports almost all its oil needs and an appreciation could lower fuel prices.

"At the end what matters is how many volatile elements are in the foreign exchange management, so as long as long-tenure, secured investments are there, they are not vulnerable for speculations," Jayasundera said.

Sri Lanka may also consider a third Eurobond later this year, after issuing two $500 million five-year Eurobonds, first in 2007 and again last year. Both are trading well above their issue prices.

"From the country's growth point of view, what we are looking for is the money coming to the real economy and the money coming in terms of a longer stay, not hot money or speculative inflows," Jayasundera said.

(Editing by Raju Gopalakrishnan)