As domestic liquidity surged and foreign investors gradually returned after a general flight from emerging markets in 2013, Philippine capital markets were riding a wave of optimism in 2014 and early 2015. The Philippine Stock Exchange’s (PSE) blue-chip index, the PSEI, hit a fresh all-time high in January 2015 and was continuing to rise in February, finally putting behind it the “taper tantrum” that knocked back all major emerging market indices in 2013.

Once known for its poor liquidity, the PSE’s reputation in that regard has improved in recent years, and equity trading volumes relative to population are on par with Indonesia and ahead of Vietnam. The exchange was preparing a technical upgrade in 2015 that will facilitate the introduction of advanced trading techniques including short-selling and options. Domestic liquidity and limitations on bank lending to affiliated groups are also fuelling rapid growth of the corporate bond market.

EARLY LEAD: The country has long had a relatively advanced stock exchange for its level of economic development, a legacy of its political and cultural ties to the US. The PSE is one of the oldest exchanges in Asia, dating to the founding of its predecessor, the Manila Stock Exchange, in 1927. A rival Makati Stock Exchange was founded in 1963, and the two completed a merger in 1994 that created the PSE.

But the Philippines’ capital markets had been falling behind as regional peers were developing more rapidly. Initially the lag owed mainly to the Philippines’ weaker GDP performance, and as recently as 1996 the Philippines still had the third-highest ratio of equity trading volumes to GDP in South-east Asia, at 31%. That was behind Singapore and Malaysia but ahead of Thailand, according to data from the World Bank. Then the PSE’s liquidity dried up in the wake of the 1997-98 Asian financial crisis, and that ratio dropped as low as 3.1% in 2003.

A rebound during the global financial expansion that followed brought the ratio of trading volumes to GDP back to 20% in 2007, and since then trading volumes have roughly kept pace with GDP growth. The ratio peaked at 22% in the turbulent year of 2013 and fell back to 17% in 2014, which was characterised by a slow and steady resurgence of prices. The PSEI ended 2014 up 22.8% and gained another 8.2% in the first seven weeks of 2015.

Probably the fairest international comparison of trading volumes is relative to national population. By that metric, the PSE’s 2014 trading volume of P2.1trn ($47.3bn), equal to $483 per capita, was roughly on par with the $123bn of equity trading on the Indonesia Stock Exchange, equal to $492 per capita, and ahead of the $35bn of equity trading on Vietnam’s two exchanges, equal to $385 per capita.

The Philippines is still far behind the leading Southeast Asian exchanges. The Singapore Exchange had $232bn of equity trading in 2014, or $42,963 per capita, and the Bursa Malaysia had $172bn of equity trading, or $5677 per capita.

The Securities Exchange of Thailand is currently the region’s busiest exchange, with $314bn of equity trading in 2014, or $4687 per capita. All trading volume numbers are from the respective exchanges.

LISTED COMPANIES: Total market capitalisation of companies listed on the PSE reached P14.78trn ($332.55bn) as of February 20, 2015, or 105% of IMF-forecast 2015 GDP. A little more than a third of that is listed for trading on the exchange, and about a quarter is true free float, as some strategic shareholders have acquired blocks of shares listed on the exchange. Most listed companies have strategic majority shareholders, and most of the rest are controlled by stable alliances of minority strategic shareholders who together own a majority.

There are 271 listings on the exchange, including three secondary listings of foreign companies. But the 30 members of the PSEI accounted for P8.97trn ($201.8bn), or more than half of the market capitalisation of domestic firms. The listed shares of the PSEI’s 30 members had a total market capitalisation of P9.14trn ($205.65bn).

MARKET REGULATION: The Securities and Exchange Commission (SEC), established in 1936 on the US model, is the main industry regulator. It approves all publicly listed securities and offerings and sets mandatory standards for all publicly listed companies. It also polices the markets, with subpoena power to investigate suspected violations of securities laws and the authority to impose sanctions.

The PSE was given formal status as a self-regulating organisation by the SEC in 1996, and was demutualised and reorganised as a stock corporation in 2001. Almost three-quarters of the PSE’s own shares are listed and traded on the bourse, and it is one of the few companies on the exchange with a majority free float. A wholly owned subsidiary, the Securities Clearing Corporation of the Corporation, acts as the central clearinghouse for trades on the PSE.

The PSE is aiming to merge with the other main player in capital markets, the PDS Group, which has three subsidiaries that play important roles in capital markets infrastructure. The Philippine Dealing and Exchange Corporation (PDEx) is a fixed-income exchange and foreign exchange market that handles trading in debt securities and repo and exchanges between the peso and US dollars. The Philippine Securities Settlement Corporation is the central clearinghouse for trades on PDEx. The Philippine Depository and Trust Corporation is the depository for corporate bonds traded on PDEx and for equities traded on the PSE and the clearing entity for PDEx and other peso-dollar transactions.

The PSE owns 21% of PDS Group and launched talks with the government’s blessing to buy a controlling stake in 2013. The other two major shareholders in PDS Group are the Bankers Association of the Philippines, a non-profit organisation controlled by domestic commercial banks, and Singapore Exchange. Local media have reported from time to time that the sides were close to a deal, but as of February 2015 nothing official had been announced. Smaller players include the Philippine Clearing House Corporation, which handles electronic interbank payments of pesos and dollars vital to foreign-currency trading, and four foreign-exchange brokers.

RAISING FUNDS: Capital raised through the PSE peaked in 2012 at P219bn ($4.9bn), which was also the peak of global inflows into Asian emerging markets. It dropped to P175bn ($3.9bn) in 2013 and was expected to come in somewhat below that in 2014 after hitting P128bn ($2.9bn) in the first nine months of the year. Overall, 2014 was a relatively quiet year for initial public offerings (IPOs), with only five smaller companies raising a combined P14.5bn ($326.3m), while two listed by introduction. That compares to eight IPOs that raised P61bn ($1.4bn) and one listing by introduction in 2013.

However, the PSE was targeting a rebound to P200bn ($4.5bn) in 2015 as markets began the year in an ebullient mood and a backlog of expected offerings were coming to market, many originally planned for late 2014 and pushed back for various reasons. San Miguel Pure Foods was expected to raise up to $336m in a preferred share sale and Profriends Group was anticipated to raise up to $172m in its IPO, PSE CEO Hans Sicat told Reuters.

In addition, the PSE is also pushing to attract more small companies to list on its board for small and medium-sized enterprises (SMEs). Two of the 2014 IPOs were on the SME board, bringing the total number listed on it to four.

Meanwhile, fundraising in corporate bond markets is surging. Net issuance jumped to $3.68bn in 2014 from $490m in 2013 and $2.89bn in 2012, according to the Asian Development Bank (ADB).

Whereas the strength in 2012 and weakness in 2013 largely reflected swings in global sentiment towards emerging markets, the surge in 2014 was driven mainly by domestic buyers (see analysis).

THE FOREIGN FACTOR: Foreign investors have a powerful presence in the Philippines’ capital markets, and their tendency to move together into or out of all of the country’s assets at once gives foreign sentiment a huge weight in overall market performance. That sentiment in turn is driven largely by the cycles of global, and especially US, monetary conditions. When US monetary policy is loosening as in 2010-12 or when private US credit markets are ebullient as in 2005-07, the dollar weakens and portfolio investment flows into emerging markets. When US monetary policy begins to move towards a tightening phase as in 2013-14 or when private credit markets contract as happened in 2008-09, the dollar strengthens and financial flows reverse. Inward flows tend to build gradually, while reverses tend to strike quite suddenly.

The strong 2014 performance was thus remarkable as it came during a year when globally emerging market equities continued to decline. The MSCI Emerging Markets index, a 23-country index that includes Philippines equities, lost 1.8% in 2014 as the US moved towards tightening and the dollar strengthened. The MSCI Emerging Markets index lost 2.3% in 2013, with markets reversing from gains to losses in May in the taper tantrum, when the US signalled it would end quantitative easing.

The Philippines’ strength owed partly to domestic investors taking charge, driven largely by a move in 2013 by the Bangko Sentral ng Pilipinas (BSP), the central bank, to boost liquidity. The BSP banned pass-through accounts that had allowed private investors to access a relatively high-interest central bank deposit account called special deposit accounts (SDAs), used to sterilise excess peso liquidity. After the move peso liquidity remained high into 2015.

But more importantly, foreign investors differentiated the Philippines from other emerging markets, seeing it as relatively shielded due its high growth, large remittances inflows and strong ties to the US economy. According to PSE data, the foreign share of trading on the PSE dropped slightly in 2014 to 49% after growing steadily to 51% in 2013 from 32% in 2009. Foreign-owned brokerages dominate the brokerage business, with the top six brokers in 2013 by equity trading volume all foreign-owned, according to the PSE. They were units of Deutsche Bank, UBS, CLSA, Maybank, Macquarie and Credit Suisse.

Net foreign buying dropped from P110bn ($2.5bn) in 2012 to P15.6bn ($351m) in 2013 and recovered to P55.4bn ($1.25bn) in 2014. The BSP’s balance of payments (BOP) data show $1.8bn of net cross-border inflows into Philippine equity and investment funds in 2012, followed by a $34m withdrawal in 2013 and a $1.4bn inflow in the first three quarters of 2014.

Foreign trades are closely monitored due to limitations on foreign ownership of many companies. Most prevalently on the PSE, foreign ownership of companies that own land is capped at 40%.

The PSE monitors foreign ownership and it must step in to prevent foreign investors from buying in any company if the foreign stake hits its legal limit. Some strategic foreign investors have found loopholes in the limits, but those are not available to foreign portfolio investors.

TAXES: Non-residents are subject to different dividend and interest tax rates than locals. Citizens and formal residents pay 10% tax on dividends, de facto resident individuals pay 20%, non-resident individuals pay 25% and non-resident corporations pay 10% to 30%, depending on home-country dividendtax policy and any pertinent tax treaty.

Citizens and residents pay 20% tax on interest, non-resident individuals pay 25% and non-resident corporations pay 10% to 20% depending on any applicable tax treaty. Certain special types of bonds incur lower or no taxes. All investors pay a 0.5% stock transaction tax on gross sales of shares listed on the PSE, or up to 10% capital gains tax on shares not listed on the PSE, depending on the size of the gain and any applicable tax treaty.

DEBT: In addition to the local corporate bond market, major Philippine companies and the government actively raise debt on international markets with bond issues. Corporate issuers pulled back from the international debt markets in 2014 as they switched to domestic issues. Net issuance of foreign-currency corporate bonds was a negative $960m in 2014 after positive net issuance of $2.92bn in 2013 and $440m in 2012, according to the ADB.

According to BOP data, Philippine banks drew a net $2.8bn of foreign bank loans in 2012, repaid $254m in 2013 and repaid $2bn in the first nine months of 2014. Other sectors repaid $444m of foreign bank loans in 2012, drew $2.2bn in 2013 and repaid $662m in the first nine months of 2014.

RECENT REFORMS: Among the major recent reforms was the establishment in February 2014 of the Financial Stability Coordination Council (FSCC), a collaborative government body loosely modelled on the US Financial Stability Oversight Council. The FSCC brings together representatives from the SEC, the Insurance Commission, the BSP, the Department of Finance, and the Philippine Deposit and Insurance Corporation. The council is intended to ensure the various financial regulators cooperate to identify and address important risks to financial stability.

Ephyro Luis B Amatong, an SEC commissioner, told OBG the FSCC was so far looking mainly at exposures to real estate. Philippines regulations have traditionally been relatively cautious on such exposures, but the issue is receiving renewed attention as the business process outsourcing sector’s rapid growth has driven a flurry of construction.

Other recent reforms include an amendment to the Code of Corporate Governance published by the SEC in May 2014, which strengthened requirements to disclose information adversely affecting a company or its shareholders.

Amatong told OBG the reform and others the SEC was working on were aimed at “aligning with best practices in connection with ASEAN integration”.

The Philippines received low marks for disclosure requirements in the World Bank’s 2015 “Doing Business” survey, which did not take the reform into account. The Philippines also received low marks overall for its protection of minority shareholders, ranking 154th in that category out of 189 countries, down from 143rd in the 2014 survey.

In July 2014 the Insurance Commission permitted insurers, reinsurers and mutual benefit associations to invest in exchange-traded funds (ETFs), a move that will support the PSE’s efforts to encourage more use of ETFs. Currently there is only one, First Metro ETF, which tracks the PSEI, but it is lightly traded, as international investors prefer to trade PSEI futures listed in Singapore. Also, in March 2014 the SEC began regulating domestic credit ratings agencies.

NEW TRADING PLATFORM & PRODUCTS: Meanwhile, the PSE was completing a major upgrade to its trading platform. In December 2014 the PSE began beta-testing its new PSE trade XTS system, which is a customisation of NASDAQ’s X-Stream platform. The new system replaced an NYSE platform that had been introduced in 2010, and demonstrated the PSE’s commitment to catching up with the latest exchange technology.

The PSE is planning to introduce equity lending for the purpose of short-selling and developing an options market after the new system is fully implemented, which was scheduled in 2015.

John Benette B Mamangun, the assistant vice-president and investor relations officer at the PSE, said the introduction of offshore products is complementary to the exchange’s plans to introduce share lending and derivatives.

“It all ties together, facilitating the work of market-makers for ETFs and preparing the groundwork for new derivatives products. We think it will make the market more attractive for hedge funds and increase liquidity by 5-20%,” Mamangun said.

ONLINE PUSH: Another major project of the PSE has been to promote retail online trading as a way of boosting retail participation in equity markets. The PSE introduced an online trading platform, PSETradex, in 2012, which allows brokers to offer online trading services to their clients without having to develop and host their own platform.

By the end of 2013 the number of online accounts had grown to 129,255, of which more than 98% were domestic retail investors. That was up by 51,061 from 2012, representing more than five-sixths of the growth in total stock market accounts, according to the PSE’s annual survey. The total number of accounts grew from 525,850 in 2012 to 585,562 at the end of 2013, with retail investors holding 96.2% of the total accounts.

According to Mamangun of the PSE, in terms of trading volumes retail investors still only accounted for around 10% of the market, but their share was growing most quickly. “What we’re focused on is getting more liquidity in the market. Of course that’s easier when markets are going up,” Mamangun said.

Mamangun said online accounts are especially popular with Filipinos working abroad in the Middle East and Singapore, many of whom invest through tax-protected personal retirement accounts that are similar to the “401K” accounts that are common in the US. He added that the PSE would like to see greater domestic use of such accounts, especially widespread adoption of employer contributions as a benefit to supplement small public pensions.

OUTLOOK: The Philippine market’s strong performance in a weak year for emerging markets bodes well for the capital markets sector and was an important show of confidence by investors in the country’s broader economic prospects.

In addition, the development of a local corporate bond market is also a promising sign and will reduce the economy’s dependence on banks to finance investment. The expected consolidation of the two major exchanges would be in line with both regional and international trends and should make a stronger and more resilient exchange business better prepared to compete with regional peers.