Inayat U. Mangla [*])
(The Karachi Stock Exchange, established in 1947, currently lists 658 companies with a total capitalization of approximately US $ 62 billion. Unfortunately KSE’s performance has been volatile because of insider trading and manipulation. For instance, after the stock market crisis in May 2002, the KSE 100 saw an unprecedented rise of 65 percent from 6,218 in December 2004 to 10,303 on 15 March 2005 thereafter it fell sharply by 32.7 percent to 6,939 on 12 April 2005. This resulted in a loss of Rs, 800 billion to investors. Pakistan cannot progress without investor confidence and this can only be achieved through effective regulation of the financial sector for which truly independent and capable regulators are indispensable. Only then can conflict of interest resulting in market manipulation be eliminated. Editor)
The last two decades have seen unprecedented growth of the stock markets of developing countries and there is an increasing recognition of the vital role of stock markets in promoting economic growth. The inefficiencies in controlled economies caused by interventionist economic policies and over-reliance on debt financing have forced developing countries to re-examine their policies and search for alternative strategies. This has resulted in the recognition of the need for a dynamic and competitive private sector and efficient stock markets as the key factors in economic growth. Consequently, measures are taken to move toward market-based economies in which efficient stock markets play an intermediary role in increasing domestic resource mobilization.
The most important measure taken in developing economies was the opening of their respective stock markets to international investors. These measures were taken in the early 1990s and resulted in historically high levels of portfolio investment in Emerging Stock Markets (ESMs) by global and regional funds. (As ESMs continue to grow and assume a more prominent role in the economy, the regulatory framework evolves alongside, albeit with delays and sub-optimum solutions, which is characteristic of political process.) It is well documented in academic and policy-oriented research that significant differences in the regulatory effectiveness and industry structure can explain the differences in the performance and stock market behavior outcomes.
The purpose of this paper in a non-technical, non-econometrics analysis is threefold: First, to evaluate the performance of the stock market in Pakistan from 1991 (when the process of economic liberalization began) to today. Second, to assess the question of how far capital markets in Pakistan have enabled corporations to raise the required capital to increase domestic resource mobilization. Perhaps a more related and direct issue is whether the stock market of Pakistan is a good barometer of the macro-economy, i.e., does the stock market have any impact/bearing on the economy? Finally, public interest theory of regulation justifies intervention in cases of market failure due to monopoly or market power and/or presence of imperfect information. The inefficiencies in market intermediation increase the cost of capital and volatility. Thus, it is imperative to examine this important issue in the context of financial/ capital markets in Pakistan. We look at these three issues in the same order.
II. Stock Market Developments (KSE) in Pakistan
The Karachi Stock Exchange (KSE), established in 1947, is the oldest and most active of the three stock exchanges in Pakistan and currently lists 658 companies with a total market capitalization of about $62 billion (or Rs. 3781 billion). The KSE 100 represents major blue chip companies and is fairly representative of the Pakistan’s stock market (See Table I). Besides the KSE, there are two regional stock exchanges in Lahore and Islamabad. These exchanges are, however, relatively inactive. For example, during 2005-2006 the average daily turnover at KSE was 462.4 million shares, while at the LSE and the ISE it was 65.4 and 1.7 million shares, representing 12 percent and 3 percent of the total market activity respectively.
Similar to other ESMs, the KSE has a limited role in raising new capital; e.g., there were only 11 new listings in the market in 2006. Despite the small size of the market, it experiences a high turnover and high price volatility. One can observe that the market experienced significant fluctuations over shorter time intervals.
A word of caution
We need to remember that financial data presented in this article are taken from various government publications. They are just numbers. Any statistics are like clay – one could make mud or bricks out of them. Their significance depends on what causes them to move. The appreciation in KSE 100 index over the whole period from 1991 to 2006 was a remarkable 637 percent, while for the sub-period of 2000 to 2006, it was even more than 700 percent. Since 2000, the Pakistani stock market appreciation was four times higher than the Indian market, despite a higher real rate of growth of the Indian economy (GDP) for the same period.
The overall annual rates of return from 1991 to 2006 on KSE 100 is estimated (from column 8 of Table I) to be 25.2 percent, with a volatility in return to be 45.5 percent. But this average annual rate of return does not reflect a true picture of the stock market. With few exceptions, the decade of the 1990s saw some of the worst performance of the market in view of several factors such as political instability, Pakistan’s response to the Indian nuclear tests in May 1998, large fiscal imbalances, international economic sanctions and exchange rate fluctuations. If we disaggregate the whole period into two sub-periods as 1990 to 1998, and 1999 to 2007, the average annual rate of return on KSE 100 for the second sub-period is more than 40 percent. From this perspective, Pakistan’s stock market has come a long way despite the political and economic turbulence of the 1990s.
It is observed from the data (col. 7) that with the announcement of liberalization in 1991, bullish trends were observed in the stock market in 1992. In terms of its performance, the KSE was ranked third in ESMs in 1992. The market could not maintain its performance in the later years of the 1990s. However, it did make considerable progress and improved substantially in its size and depth.
Table I : Pakistan’s Annual Basic Stock Market Indicators: Karachi Stock Exchange (KSE 100)
|(Bill Rs.)||(Bill No.)||(Bill Rs.)||(Bill Rs.)||%|
** The Base Index in the FY 2001 was changed back to 100 points.
Source: Karachi Stock Exchange (KSE), State Bank of Pakistan Annual Reports and, Economic Survey, M.O.F Govt. of Pakistan
Explanatory Symbols are: N = Number of Listed Companies; MC = Market Capitalization; ST = Volume of Shares Traded; TV = Trading Value; TOR = Turnover Ratio; SBGI = State Bank General Index; KSE = Karachi Stock Exchange; ROR = Annual rate of returns on KSE 100
From the data on trading shares and its volume, a skewed distribution of stocks traded is observed for the KSE. This skewness in trading at KSE is in terms of size, trading patterns, volume of broker’s trading and weighted value of stocks in the index. Skewness refers to the extent to which a frequency distribution or probability density is asymmetric, and hence, skewed as compared to a normal distribution. This is particularly true for the top 20 stocks accounting for 85 percent of the overall turnover.
We also note from Table I that since 1991, the overall number of new listings, market capitalization and trading volume has increased significantly. These developments were accompanied in the early stage of liberalization by inflow of foreign capital through the Commonwealth Equity Fund, the Pakistan Fund, and the Credit/Lyonnaisee Pakistan Growth Fund.
Despite the unfavourable economic and political events in late 1990s, the market made considerable progress in that decade largely due to privatization moves and liberalization measures. By 2000, the number of companies listed rose to 762 while market capitalization increased by more than six times to Rs 379 billion. The increase in annual turnover of shares was also phenomenal as it increased by more than 77 times to 46 billion.
The market started the new millennium with significant expansions in all indicators except for number of listings. By June 2007, the market capitalization increased by more than seven times to Rs 3.8 trillion whereas the volume of shares increased by more than 85 percent to 105 billion shares. The KSE index registered a gain of more than 200 percent. With these significant developments, the KSE has been one of the best performing markets in recent years.
The market restored after December 2001 and kept on moving on a higher profile for the next five years. The phenomenal expansions in market capitalization and turnovers are clearly evident from the data. The figures on all these indicators show that from 2000 to 2006, the bullish trend of the market has continued in terms of market capitalization, shares traded, turnover of share as well as the value of KSE index. Several explanations exist for this upbeat performance, ranging from post-9/11 events to Pakistan’s geo-political situation to the improvements of fundamental economic factors.
Despite Pakistan’s recent political problems, it is evident that the country’s stock market is soaring to record levels in recent years. The main reasons given by financial analysts for this outcome are successful privatization program, financial deregulation and sound macroeconomic performance of the economy. The result is an unprecedented inflow of fresh foreign and local investment. For instance, the spurt on KSE has been powered by a record yearly inflow of foreign funds, which stood at $800 million at the end of June 2007. Similarly, total foreign direct investment in FY 2006-07 has reached $6 billion, up from $4.5 billion in FY 2006.
At the time of this writing, The Wall Street Journal – the oracle of a stock market’s performance – has this to comment:
“Structurally, the economy now is on much firmer footing to sustain growth for next three to five years,” says Mudasir Malik, director of Karachi-based BMA Capital Management, which runs the $30 million Pakistan Opportunity Fund, the country’s first, offshore, dollar-based fund.
It is also estimated that:
Foreign funds now own 20% of the shares on the Karachi Stock Exchange, which has a total market value of $60 billion. Foreign investors have targeted the financial, energy, textile and cement sectors in particular. Popular stocks with foreign funds include Oil & Gas Development Corp., Pakistan State Oil, National Bank of Pakistan and Pakistan Telecommunication”
At present, there is debate whether these trends are sustainable after the effects of the positive political externalities are exhausted. However, the data speaks for itself, and as the famous 20th century economist John M. Keynes said, “Once the facts change, I change my opinion.” Given this analysis, the final judgment can only be drawn with time.
After discussing the performance of the Pakistan stock market, a few brief remarks on the various sectors of the stock market are warranted. The phase of bullish trends in the market is largely due to the trading in some key sectors such as textile, cement, fuel and energy, finance, chemicals and pharmaceuticals. It is observed that approximately one-third of the companies listed at the KSE belong to the textile sector, although its share has gone down marginally over time. The financial sector, whose 2006 share is now about a quarter of the market, is another critical sector. The data also suggests that the market capitalization has been the highest in fuel and energy. In the last few years about 40 percent of the aggregate market capitalization belongs to this energy sector. It is interesting to note that in terms of listings the share of this sector has never crossed 50 percent.
To see the market concentration, we look at the two indicators at the company level and examine the shares of top ten companies. The indicators are the market capitalization and the turnover of shares that represent the size and activity respectively. In this context we focus on the last five years, from 2002 to 2006, during which both the indicators reached new heights. Here it is noted that about half of the size of the market is captured by ten companies, such as OGDC, Pak Tel, Pakistan Petroleum Limited, Pakistan State Oil, National Bank of Pakistan, MCB, Fauji Fertilizer, Pakistan Oilfields, Hub Power, and Sui Nothern Gas among others. Thus it is clear that in general, the market is highly concentrated. It is worth mentioning here that both OGDC and PTCL, which hold major shares in the aggregate market capitalization, significantly affect the KSE 100 index which assigns weight to companies included in the index according to their market capitalization. Similarly, about 87 percent of the total turnover of scripts is exchanged in top ten companies such as OGDC, PTCL, Hub Power, PSO, National Bank etc. This data indicates the high degree of concentration of the market. In recent years, this concentration has led to increased market volatility and manipulation (as discussed later). These fluctuations in the market are largely due to the trading in the shares of these companies. This is not the sign of a healthy market and measures are needed to reduce the concentration of the market.
Stock Market Valuation
A popular gauge of a stock’s value in a market-based economy is known as the Price Earnings Ratio – P/E. Financial markets analysts are of the view that Pakistan’s recent market appreciation can be justified based on this fundamental factor, and that stocks are significantly cheaper than those in other Asian markets such as India, China, Thailand, etc. For instance, in 2007, in Pakistan, stocks are trading at a P/E multiple of 10, which is almost a 40 percent discount to average P/E multiples of other Asian markets. As financial markets value stocks on rich future cash flows, investors are willing to pay a premium price for the top 20 stocks in Pakistan.
III. Stock Market and the Economy
Having presented the analysis of the stock market of Pakistan in the previous section, we want to relate these developments, if any, to the macro-economy. Our interest is to know whether the improved performance of the market has any impact on the economy of Pakistan. This issue in itself is scope of a separate article and needs a more sophisticated estimation and analysis. However, I have summarized the main macro financial variables of Pakistan’s economy in Table II. The data on these variables includes the annual growth rates of nominal and real GNP, inflation rate, nominal and real growth rate of money supply, two measures of interest rates and rate of return on the stock market respectively.
The data shows a general deterioration in the economy in terms of real variables during the 1990s, but a rebound in the present decade. Without questioning the validity of inflation rate data over time, it must be observed that inflation rate is one of the main culprits in the macro equation of our economy. In reference to monetary policy in controlling the true double digit inflation rate in Pakistan, the State Bank of Pakistan (SBP) has a long way to go. While the direction of monetary policy in recent years is right, the degree and speed of achieving this lofty goal is still very slow. For instance, how can the SBP claim to be supposedly following a tight policy in wake of the fact that the real interest rate (the difference between nominal rate and the inflation rate) in Pakistan is practically zero or even negative? Finally, as far as explaining the relationship between the real sector of the economy and the stock market, I hypothesize a very weak relationship.
From Table II, we observe that the average annual return on stock market is more than 25 percent, whereas the real growth rate of economy (5 percent) or even the nominal growth rate of economy is less than 16 percent. However, the volatility in stock price index measured by the standard deviation is much higher. Hussain (2004) has shown with a rigorous statistical analysis that the relation between the two variables (as measured by correlation coeff.) suggests that “neither the stock price variable nor the real variable (y) are significantly correlated with each other.” I tend to agree with these findings, which should also hold for the empirical estimation of more recent data. Tentatively, we can conclude that there is no strong impact of stock market performance on the economy.
Table II: Macro-Financial Indicators of Pakistan
Source: Karachi Stock Exchange (KSE), State Bank of Pakistan Annual Reports and, Economic Survey, M.O.F Govt. of Pakistan
Explanatory Symbols are: Yn = Nominal GNP growth rate, y = is real growth rate of the economy, p is average inflation rate excluding food (core), M2 = growth rate of broader measure of money stock; m = real growth rate of money, R = short term interest rate (discount rate), RC = Interbank call money rate, ER = Pak Rs. Exchange rate, ARS = Average yearly return on KSE 10
IV. Some Pitfalls in the Market
Despite the relative small size of Pakistan’s stock market in the region, it experiences a high degree of turnover and high price volatility. The KSE represents only 0.7 percent of the total capitalization of emerging markets, compared to the 8 percent share of the Bombay Stock Exchange (BSE). Yet, it is interesting to note the sharp contrast between Pakistan’s capitalization ratio, which is low, and the relatively very high turnover ratio of more than 300. This characteristic probably reflects some noise trading and speculative elements in the market. It is also observed that P/E ratio and price to book value of Pakistani companies is low. KSE’s degree of correlation with S&P Composite Index is 0.32, which reflects a low degree of integration with the international stock markets. We also note that KSE has a limited role in raising new capital, e.g., on average, there were only five new listings per year during this decade.
As mentioned earlier, and also evident from the data in Table I, the KSE experienced a steady bull run as reflected in both the KSE 100 index and trading volumes, starting just after the last stock market crisis in May 2002, which accelerated toward the end of 2004. The KSE 100 saw an unprecedented rise of 65 percent, from 6,218 on 31 December 2004 to 10,303 on 15 March 2005, along with an increase in the value traded from around $300-400 million to $1-2 billion per day. However, the market turned negative in the second half of March 2005 and the index dropped to as low as 6,939 on 12 April 2005, a decline of 32.7 percent from its peak. The sharp rise in the index could not be explained by any change in economic fundamentals. The following precipitous fall is also somewhat of a puzzle. Such a meteoric rise in index and a subsequent crash is indicative of a classical speculative bubble in the history of equity market in Pakistan. What caused this crash leading to a loss of Rs. 800 billion to the investors? One could see some parallels to the 1920s in the US and 17th Century ‘Dutch Tulip Effect’ in Pakistan.
The Badla or Traditional Carry Forward System
Badla, meaning something in return, is a local term for a forward trading facility, and has been an old and traditional informal institution common to both Pakistan and India. A badla transaction is essentially a repo transaction carried out in a separate after-hours market trading where the borrower who takes the badla from a badla broker, carries forward his security exposure from the current settlement period to the next one, by sale of his position in the present period and its repurchase in the subsequent period at a predetermined price differential. In the event of a purchase, the investor may want to carry forward the transaction to the next settlement cycle and for doing so, he has to compensate the seller who sold it with an intention of getting cash.
Badla has been “blamed” as one of the reasons for the March 2005 crisis. Pakistan’s influential financial newspaper, Business Recorder, stated two problems with the “badla” financing: first, badla financing is only open to a small number of market players, which also includes financial institutions, as opposed to share trading. Second, badla financing is provided by short-term investors and the hot money can disappear overnight. During 2004-05, KSE investors were willing to borrow at exorbitant Badla rates (which were capped at 18 percent in KSE but rose in the uncapped Lahore Stock Exchange to over 100 percent) because the accelerated rise in stock prices made even expensive borrowing feasible. The COT (badla) financing ranged from 33 percent to 45 percent of investment at KSE throughout this period. The higher demand for badla investment increased the average badla rates to 11.4 percent in 2004, ranging from 12 to 19 percent, from 9.4 percent in 2003, even though market interest rates remained low through most of 2004. The growing availability of badla financing brokers and institutions added to the buying frenzy, though some of the major badla providers were simultaneously selling in the futures market. In other words, “there was a strong nexus between lenders and brokers/investors who could influence market sentiment to their own advantage.” (Task Force Report, 2005).
What is peculiar about Pakistan’s stock market is that besides badla financing, other factors which contributed to this “bull run” included increased liquidity due to higher foreign remittances, a regime of low interest rates, IPOs of public sector enterprises marked for divestment and floatation of more mutual funds. Statements from government officials linked the rise in the KSE index to good economic management and indicated that the market was destined to rise further. The government’s announcement of the impending accelerated program for the privatization of key public sector corporations fuelled the bullish sentiment. The conduct of corporate officials contributed to the market speculation; for example, rumours of new oil and gas discoveries which would raise stock value manifold that went un-refuted or clarified by the corporate management. There were also allegations of “wash trades” and “pump and dump” plays by brokers.
The then-chairman of SECP (who was later fired by the government) stated on 16 July 2005, that “badla was the root cause of almost all previous crises at the bourses, and was to be routed out, and that the badla and margin financing could not co-exist.” The Task Force recommended that there was a need for structural reforms and steps were required to protect public interest by ensuring that the financial might that has been accumulated by the stock brokerage and badla financing institutions should be effectively checked and brought to a reasonable size to ensure that they are unable to manipulate the market and adhere to international practices. Our technical econometrics research (e.g. Uppal and Mangla, 2006) has shown that indeed badla had a significant impact on increased volatility on KSE. It is worth mentioning here that the badla system was replaced by ‘CFS’ – a disguised name for badla and perhaps a bit less volatile system. However the CFS is by no means a replacement for the conventional method of ‘margin’ financing.
The foregoing analysis and episodes of extreme market volatility suggests that the regulators in Pakistan should be concerned about excessive volatility since, among other factors, it reflects possible market manipulation and speculative trading. A lack of trust in the fairness of markets due to the potential for manipulation and irrational trading, highlighted by recurring scandals, scams and speculative behaviour imposes implicit costs on the market participants and increases the cost of financial intermediation.
There are two other aspects of the market which may have a direct bearing on the regulatory response and its effectiveness in dealing with market manipulation and volatility in Pakistan. First, there is a difference in the industry “structure” and competition among the stock exchanges. The KSE is still the dominant player with an 85 percent share of the trading activity. Secondly, there seems to be a significant gap between regulatory enforcement and effectiveness of public policy. Nageswaran and Krithivasan (2006), for example, claim that only Singapore, Hong Kong and India are effective in enforcement among Asian countries.
According to a survey conducted by La Porta et. al., (2006) Pakistan scores rather low on the indices of (i) orders to issuers, distributors and accountants (ii) criminal sanctions and (iii) public enforcement which capture the extent to which a public regulator exercises investigative power and its ability to impose penalties. Pakistan’s score on these three indices is 0.17, 0.08 and 0.58, compared to India’s 0.67, 0.83 and 0.67, respectively. Khawja and Mian (2005) remark with respect to Pakistan that, “Thus, it is not surprising that to date there has hardly been any case in which a broker has been prosecuted for improper activity.”
In summary, the bullish sentiment and volatility on the KSE continued unabated despite the measures taken by the SECP to curtail speculative trading allegedly fanned by the badla system. The response of Pakistani regulators in dealing with the market speculative behaviour appears to be much weaker. The regulators only pursued institutional restructuring mainly focusing on replacement of the badla system with Continuous Financing System (CFS). No criminal or civil charges were filed, and no recovery was sought. This response may have been perceived by the market as weak, and may not have conveyed a strong signal to the investors regarding government’s resolve for effective enforcement. It is possible that extra-market manipulations by speculators may have frustrated the efforts of the KSE regulators and the debate is still going on. Nevertheless, in the case of the KSE, its near monopoly position may have been a factor in frustrating the goals of the regulators. Future reforms in Pakistan should focus on reducing conflict of interest and agency problem in both private and public sectors improving enforcement and surveillance, as well as creating a more competitive environment among the stock exchanges.
The main message from this article can be briefly summarized in a quote from the Business Recorder (Pakistan) of 11 September 2007: Title – SECP Seeking Power to Freeze Bank Accounts.
“Good Governance has not been our hallmark, be it the government, bureaucracy and, until recently, even the judiciary. The fact is that, right now, we face a crisis that is rooted primarily in less than logical and judicious governance….Pakistan needs an enormous amount of investment in every sector and to ensure that, investor confidence must be enhanced along sustainable lines. To achieve this all-important objective, it is imperative that regulation of the financial sector stays within the purview of truly independent and capable regulators. By any standard, SBP is competent to do that job…. SBP’s independence must not be diluted through controversial legislation.”
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Dr. Inayat U. Mangla is an eminent Professor of Finance and Commercial Law.
See Mangla and Uppal (2006) and Khawja and Mian (2005).