June 06 - 12, 2005

A phenomenal rise in the KSE-100 index, followed by drastic decline in March 2005 has brought the whole efficacy of stock market into question. Opinions on this turtle round of KSE have ranged from the market manipulation of big players to the technical correction of the market, with plethora of causes in between. Is there any rational explanation of this phenomena or KSE remains an enigma, which eludes a plausible explanation? We will strive to answer this question in this article.

Our objective is to begin with a macro picture, by providing information on the purpose and structure of capital markets in the country. This explanation will be followed by a micro-level analysis of the recent build up and subsequent crash in the stock market. Our focus will remain on making a plausible line of thinking of this jigsaw puzzle.


Capital markets play an important role in financial intermediation in any capitalist economy. Financial intermediation could be explained as a process, whereby savings from many are transferred to users of capital in a prudent and cost effective manner. Banks are in the forefront of this financial intermediation, as they are the biggest collectors of money deposits, which are subsequently be lent or invested at rates higher than deposit returns. The spread between deposit and lending rates is the margin of banks, through which they meet their running expenses and make profits. Usually bulk of the deposit base and lending portfolio of the banks is of short-term tenor. Banks cannot undertake high long-term lending, as it will create a timing mismatch in their assets and liabilities.

In order to provide long-term capital to the companies, either government has to provide financing through specialized institutions such as Development Finance Institutions (DFIs) or companies can raise capital by selling their bonds or equity stock in the capital markets. Owing to liberalization of the economy, the role of the DFIs has become somewhat circumspect due to their high risk profile and lesser exit options.

Capital markets could be segmented into primary and secondary markets. Primary market is used for the first time issuance of bonds and stocks. Company sells their bonds and stocks to a group of institutional and retail investors through a financial intermediary, which is usually an investment bank or a brokerage house. The offering is called the Initial Public Offering (IPO) of the bond or stock issue. Ones the product is sold in the primary market, its trading gets started in the secondary market. This secondary market is known as stock exchange, whose recent crisis is our topic of discussion.

Secondary market plays dual role for financial intermediation. It provides liquidity and facilitates efficient price discovery. Liquidity could be defined as an ease with which investors can sell and buy financial instruments. Stock exchange provides a platform where capital providers of primary markets can exit their investments on will. This flexibility reduces the illiquidity risk of primary investors, hence decreasing the risk premium on primary issue. Secondary markets also provide signals for efficient price discovery, which facilitates pricing of issues in primary markets.

We take an example of a stock IPO for the explanation of these roles. An investment bank is advising an oil marketing company for raising funds through an equity IPO. The marketability of the share depends upon its prospects and pricing, for which the bank can take the secondary market prices of other oil marketing companies as a proxy. It will be the benchmark against which primary investors will ascertain the marketability of the share. Primary investors will be willing to pay high price of the share, if corresponding shares of other companies are trading at higher price. In this manner, secondary market proxy will reduce the cost of capital for the issuer of equity. Ones trading commenced in the secondary market, the primary investor can exit from his investment on price determined by demand and supply scenario.


Stock markets around the world are organized either as a mutual club of exclusive members or de-mutualized body as a corporate. In Pakistan, the three stock exchanges are mutual clubs of exclusive members. There are efforts under way by Securities & Exchange Commission of Pakistan (SECP) to de-mutualize and integrate the three exchanges. KSE remains the oldest and largest stock exchange, with total membership of 200, out of which 140 are active members.

There are over 650 companies listed in KSE. However, daily trading takes place in 250-300 shares, with around 30 shares could be termed liquid shares, i.e. shares with high turnover and 5-6 shares driving bulk of the turnover. Money flow in the share trading will depend on the extent of liquidity available. Investors can either purchase on cash or leverage its purchase through Carry Over Trade (COT) or "badla" or deferred its payment in futures counter. COT has been restricted to seven shares and will soon be replaced with margin financing.

Price determination remains a controversial topic in stock markets around the world. We have two major schools of thoughts of fundamental and technical analysis. Fundamental analysts based on price determination of the share on its intrinsic value, which in turn is reached through valuation models incorporating companies' performance, management strength, industry prospects and comparative companies. On the other side, technicians believe that by charting the trend of past prices and volumes, the future price trend of the shares can be predicted.

Client base of the stock market could be segregated into institutional and retail clients. Mutual funds, banks, financial institutions are the major institutional clients, which usually work on cash basis, i.e. picking up delivery of shares purchased. Retail clients include day traders and customers buying on leverage. Different entry and exit timings of these customers provide liquidity to the market. Investor participation in share trading is linked with his perception, which is usually event driven, such as companies' results, change in macroeconomic indicators, political stability, fiscal and monetary directions.

As barriers to entry are low in stock trading, investors follow a herd like behavior, i.e. if a buying momentum is building up, majority of the investors will become sole buyers, hence driving the prices to new high and the same will be done on reversal of the prices. This pattern could be interpreted as a pendulum swing. At high end, we have excesses known as asset bubble and on the low side, we have market crash. It is pertinent to note here that stock investment is one of the investment avenues. In normal course of existence, stock markets operates in small ranges, the abnormal events of rise and crash are fewer and reflects the self-correcting mechanism of the markets. Casualties are there in a market crash, however, one also need to consider the amount of wealth created during the bull market.


The genesis of the recent crash of the KSE could be traced to higher money growth, lax regulatory control, greater investor greed and negligence of fundamentals. Over the head of higher forex inflows, Pakistan has witnessed a domestic money growth of over 15% during the last 4 years, whereas its GDP growth has hovered around 5-6%. Despite unprecedented increase in credit off take, excess amount of money has found their way in stock and real estate markets. Prices in both the markets shot to new heights. Now the question arises whether these prices are rational or not. With low returns on other investment avenues and avoidance of taxing speculative activities (which ultimately gave way to higher inflation), speculators had a hay day of making substantial profits.

In a span of 4 months between November 2004 and March 2005, KSE-100 index registered a phenomenal 100% rise. With their heavy weighting in the index, government-owned entities poised for privatization led this rally. Every market possesses a speculative element, which is essential for the provision of liquidity, however, if it is stretched to limits, a probability of break down enhances.

At its peak in March, KSE was recording a daily share turnover of 700-900 million, with traded value hovering over PKR 100 million. Market capitalization touched the peak of PKR 2,818 billion. Bearish spell in the aftermath has resulted in the loss of around PKR 1,000 billion in market capitalization, with trading volume oscillating between 200-250 million shares and traded value of PKR 20-25 billion.

During this bull run, investors expectations of further rises kept on building up, as evident from the given graph. The futures market played a significant role in sustaining this ascend. Future prices of the shares remain usually higher than ready share prices, as investors have to incorporate the opportunity cost for the deferred payment for the future contracts. As mentioned above, institutional investors, with larger resources have a greater holding power. Big investors adopted a strategy of buying shares in ready counter and selling the same in future counter. With market going north, retail investors became the buyer of future contracts due to their deferred payment nature and expectations of further market rise. This arbitrage opportunity resulted in future volumes rising higher than ready trading and premium between ready and future prices kept diverging further.

The drama started unfolding towards the end of March future contracts. Before the settlement date of March contracts, the ready market started declining owing to decrease in leverage money for share purchasing. Now, here we take into account the role of leverage money in the sustenance of bull run. Till mid-March 2005, institutions kept this money available for badla financing, however, thereafter they started reducing their exposure over increased risk perception. This reduction pulled the rugs under the feet of the bull market.

Hardest hit were the investors of future contractors. With prices moving down and circuit breakers coming into play, profits of buyers in future contracts quickly turned into losses and they were even unable to exit their investments in time, as circuit breakers restricts fall in a share in a single day trading. SECP and State Bank of Pakistan have to arrange a consortium of financial institutions to purchase the shares of OGDCL from retail investors, as they were unable to offload them in the market.

Here, we want to talk about the role of SECP, the regulator, which remained passive during the bull run. However, in the aftermath, it constituted a task force for ascertaining the causes of crash and imposed stringent conditions on future trading. It also took tough stand on the phasing out of badla financing. These measures resulted in uncertainty, liquidity crunch and restrictive future markets, which further exacerbated the market situation. Till present, market is still in the grip of uncertainty, whereby the mechanism of margin financing replacing badla financing is still not clear. A tussle between brokers and SECP is still going on the issue of future rules. It appears that SECP is only playing a role of regulator not facilitator. With market down, it needs to provide some support for enhancing market activities. Its stringent policies are further depressing market sentiments. With secondary market collapsing, one could expect cost of capital for primary market going up, hence affecting business competitiveness and purchasing power of broader population.

We have tried to provide the rationale behind the recent volatile movements in KSE in this article. This is not an effort to exonerate any participants from its role in this crisis. We want to say this in the end that greed without an exit strategy is recipe for disaster.

The author is Vice President, Institutional Sales Zafar Moti Capital Securities (Pvt) Ltd.