LEARNING FROM MISTAKES?
By ASHRAF KHAN
June 06 - 12, 2005
Pakistan's stock market became investors' haven in 2002 when the US rediscovered the country as a front-line ally in the war against terror, following the world shaking tremor of September 11, 2001.
Economy went robust, funds flew in the market, and investor confidence was radiantly bolstered. Over the years, (almost three consecutive years) it remained undeterred and the benchmark of Karachi Stock Exchange 100 index rose 388 percent from 1,273 to 6,218.
Market capitalization subsequently took a quantum leap from $5 billion to about $30 billion in a short span of time. However, first quarter of the current calendar year made history at the capital market.
The saga of Pakistani stock market has all the marks of a financial legend — record-breaking numbers, and limitless capacity. It grabbed headlines because of its race to new highs on the back of robust economic recovery with remarkable corporate profit growth. The mighty edifice developed during the past three years, it however, suddenly caved in when investors rioted in March at the stock exchange to protest heavy losses when the jubilant investors were caught by surprise by an unexpected crash. That heavy fall came at a time when the booming market was shining as the seventh best performing market of the world inviting the international community with strong and alluring signals.
Naturally, the priced balloon caused considerable distortion to otherwise strongly improved image of the economy blowing a dent to the efforts of Islamabad to sell Pakistan abroad.
Before the crash, the index stunningly surpassed the psychological level of 10,000 points. In the quarter (Jan-March) equity values were up by 24.9% as measured by KSE-100 Index. The market capitalization ended the quarter at US$36.1 billion, up 24.4%. High and low of the Index, on closing basis, were 10,303 and 6,220, respectively.
Similarly, market capitalization went as high as US$47.4 billion on March 15 against lowest of US$29.0 billion was seen on January 1. Average daily volume (both ready and future market) at KSE remained at 842 million shares during the quarter. This translated into Rs85.3 billion (US$1436 million) turnover on a daily basis. But the interesting thing to note was the turnover in the future market. At KSE volumes in 30 stocks in which futures trading are allowed was 229.5 million shares a day. That is on an average Rs32.6 billion (US$550 million) was traded daily on the stock futures counter.
A Jan-Mar 2005 quarter witnessed unprecedented boom in the KSE-100 Index. Privatization front was the single primary factor that triggered buying rallies. During the period Privatization Commission invited Expression of Interests (EoIs) for Pakistan Petroleum Limited (PPL) and Pakistani State Oil (PSO) auction whereas significant progress was also made in case of National Refinery Limited (NRL) that has been sold last week for 274 million dollars and Pakistani Telecommunication Company Limited (PTCL) sell-off.
However, a phenomenal increase in Oil and Gas Development Company Limited (OGDCL) share price and its contribution to KSE-100 index rise outperformed all other positive macroeconomic as well as microeconomic developments. Nearly two-third of KSE-100 Index of 4,085 points from Jan 1 to Mar 15 was contributed by OGDCL.
Warren Buffett, a well known US funds manager usually quoted with his famous saying: "derivatives are financial weapons of mass destruction", was really a literal application on the Pakistani markets. Pakistan's equity markets witnessed one of their darkest phases in the history thanks to risk oblivion of the futures market.
Until recently, there was little awareness of derivative products even amongst market-literate investors. Phasing out of Badla market and lack of progress on margin financing side made investors rely on stock future market for leveraging. Since most of the future trade carried by the speculators, instead of hedgers, a sudden decline in share prices with low volume of trade entangled many weak holders in the trap with future holdings.
This eventually forced a free fall in the equities value that trimmed by 25% (2595 points) in just 8 trading sessions at KSE. Derivatives have been highly controversial for a number of reasons.
For one they are very complex. The complexity of derivatives means that sometimes the parties that used them do not understand them well. Consequently, more often than not they are used improperly, leading to potentially large losses. This was what exactly happened in the Pakistan market which is currently passing through difficult times because of excessive buying in the March future contracts? Ahead of many developed and emerging markets, Financial Futures on individual stocks started in Pakistan in 2001. The main objective was to counter declining volumes due to the implementation of T+3 rolling settlement systems, reduce reliance on problematic Badla financing and to provide hedging facility to the investors.
Initially, investors' interest in this product was not enthusiastic. But ever since PPL listing in September 2004, investors started focusing on this stock futures as badla facility were not provided in PPL stocks. Fascinated by the crazy Bull Run, investors focused on stock
Futures started gaining momentum to the extent that stock Futures' daily volume (in rupee terms) in 30 stocks was more than the ready market volume in 661 scrips. Since Jan 2002, when the stock market rally started, share prices are currently passing through the fourth downward correction (that is fall of 10% or more) in local bourses).
The first one was in January 2003 when the Index fell by 600 points (20%) in 6 weeks and then recovered. Later on in September 2003, the Index underwent a major 7-week correction of 800 points (18%). Then due to surprising tax on share trading, KSE Index went down by 550 points (10%) in May-June 2004 and then recovered.
But this time around, the Index has fallen by 16% (1604 points) in only 5 trading sessions. And an important feature this time is that investors are not able to book losses, thanks to stock futures market that has a defined period of maturity. In these 5 sessions average daily turnover was only 334 million shares in ready market and 337 million in futures market while before that in the first two weeks of March the average daily volume was 724 million in ready and 428 million in futures market.
Another aspect of the KSE is a skewed size-distribution of stocks traded. Of the 758 firms listed on the stock exchange, only 648 are actively traded and of these the top 25 stocks accounted for 75% of the overall market capitalization and 85% of the overall turnover. In fact, such a skew is common even amongst smaller European markets where the five most traded shares constitute more than 70% of turnover — while the corresponding share of the top 5 represent 68% share for the KSE.
In comparison to stock size, the distribution of broker size and coverage for the universe of brokers (147) trading on the KSE is not as skewed. To summarize, a small and shallow equity market with high turnover, little real investment activity, high price volatility and skewed size distribution is all features of KSE that are very typical of emerging market stock markets around the world.
How costly is the poor governance of market intermediaries? Is truly reflected when brokers trade on their own behalf, they earn annual rate of return i.e. 50-90 percentage points higher than those earned by outside investors. Neither market timing nor liquidity provision by brokers can explain this profitability differential. Instead, some researchers have found compelling evidence for a specific trade-based "pump and dump" price manipulation scheme: When prices are low, colluding brokers trade amongst themselves to artificially raise prices and attract positive-feedback traders. Once prices are raised, the former exit, leaving the latter to suffer the ensuing price fall. Conservative estimates suggest these manipulation rents can account for almost a half of total broker earnings. These large rents may explain why market reforms are hard to implement and emerging equity markets often remain marginal with few outsiders investing and little capital is raised.
However, capital rose at KSE but not because of new listings from private sector companies. Instead initial public offerings by public sector organizations steered up the market.
A conclusion of a study conducted by some independent researchers suggests that such manipulation rents are large in absolute terms. Conservative estimates reveal a $100 million (Rs6 billion) a year transfer of wealth from outside investors to principal/manipulating brokers — a considerable share of market capitalization. In a country with per-capita GDP at $700 this is a significant wealth transfer.
Moreover, estimates also suggest that this is significant relative to the total earnings of brokers (i.e. including estimated brokerage commission), accounting for 44% of these earnings.
Brokers mostly act as principals and not as intermediaries, this has led to extremely high turnover — extensive speculation — very little genuine investment activity with hardly any capital raised.
To restore investor confidence: (i) stock exchange management should be freed from broker influence and (ii) government must support and visibly seen to be supporting the SECP's reform agenda. SECP reported to the President in its report prepared in 2001 to bring about reforms.
Nevertheless reforms by the government regulatory authority, such as appointing independent (non-broker) members in the board of directors have been targeted at weakening broker influence, although to date these reforms have had limited success. The issue of broker control has been one that has historically plagued markets during their early stages and appears present in emerging markets today.
Broker's capabilities of manipulation the market appear to be on rise as the recent crash conspicuously hinted at the flaws. Their connivance with the listed companies, with the policy makers in Islamabad, whose public statements turn the market upside down or vice versa, keep weaker or small investors are exposed to high vulnerability. Some quarters even feel that the crash was engineered in connivance with the power circles.
The SECP had constituted a task force to independently study, examine and review the factors contributing to the recent eventuality in the stock market and to suggest measures for market stability, transparency, restoration of investors' confidence and reinforcement of investor protection.
The task force is headed by former Federal Tax Ombudsman and Judge of the Supreme Court Justice (Retd) Salim Akhtar and has Dr. Mohammad Zubair Khan, Shahid Hafiz Kardar and Sultan Allana as its members, while Adil Naeem Khan is acting as Secretary.
The task force has given a mandate to identify the causes for the current market situation, analyze the role of various market participants in bringing about the recent stock market events, and investigate the allegations of market manipulation, insider trading and other market abuses examine the role of front-line and apex regulatory in the recent market situation and review the impact of discussion by market participants, including research analysts together with media in the recent events.
The task force would recommend regulatory and operational reforms for market, the efficient monitoring and accountability of the market participants and would also propose measures for strengthening and consolidating the regulatory regime particularly with a view to enabling emergency intervention, preventing systemic risk and ensuring market stability.
It was authorized to form sub-committees, co-opt members and appoint auditors or other professionals, obtain information and documents, require attendance of any persons, commission audits of the stock exchanges, brokers and financial intermediaries and generally inquire into and investigate any matter having any association with the recent market events. The task force is vested with all the powers necessary for the fulfillment of its mandate. The task force is due to furnish its report soon as the deadline has already lapsed on June 2. Whether this report fixes responsibilities or not, whether it is made pubic or not but it will definitely teaches a lesson to all the stakeholders especially to the regulators and the bourses management to learn from the past and straighten their objectives
The regulators seem determined to beef up efficacy of the already laid regulations with regard to risk management and cut the market manipulators to size and that could lead to trim the activities to a modest level unlike huge turnovers witnessed in recent past.
Keeping in view the strong fundamentals on economic as well as corporate sector front, the market has all reason to behave stable in the next fiscal year. The deadlock between the SECP and KSE has been over now which large arose with regard to futures trade.
In a last week meeting between KSE management and SECP a number of decisions were taken to boost stock market morale. The position limit in future trading has been enhanced from one percent to three percent in each scrip by each member based on free float. The 3 percent maybe enhanced to five percent on the implementation of pre-trade verification at the KSE by July 2005. The requirement of 100 percent cash margin in case of exposure exceeding Rs200 million has been reduced to 50 percent cash margin and 50 percent margin in eligible securities in the futures market or bank guarantee from a scheduled bank acceptable to the exchange. Existing futures contracts based on deliverables will be allowed for trading until September 2005. These contracts would be standardized. In the event of any settlement problem in the deliverable futures contracts the principle of hammer price shall be followed to settle the outstanding trades.
With effect from October 2005 the stock exchanges would introduce standardized contracts for 30, 60, and 90 days on cash settlement basis. The measures are largely meant to remove broker's apprehensions and reservations.
The forthcoming budget is also likely to bring in some measures to prop the volatile market. Last year's budget was a big shock for the stock market. It brought with it a turnover tax called capital value tax (CVT) on shares that was later revised downwards. CBR has reportedly proposed doubling of such taxes levied on the investors and Stock brokers. However, the government will try to maintain status quo as the local bourses are still under the shock of March 2005 crash.
The board has also has proposed to double presumptive withholding tax from 0.005% to 0.01% on stock brokers. For couple of years now, there are pre-budget speculations about the cut in the sales tax on commodities and corporate tax rate. The proposal to increase gap between the tax rates of listed and the government may also according to market circles, ignore non-listed firms. The existing tax structure on dividend income is likely to go on. After a sharp rise in interest rate there are logical speculations that NSS rates would be adjusted upward in line with PIB yields. The government, in order to gain popularity, may announce an increase of 2-3% on selected saving schemes in the budget, said market sources said.
Equity markets are exempted from capital gains tax on sale of shares up till June 2007, thus one may not expect any major change in the turnover tax. Moreover, a better than expected collection of tax on share trading also justifies no change in this tax structure. Expectations of reduction in GST, corporate tax rate and levies on cash dividend would be slightly unrealistic keeping in view strong corporate sector profitability, higher dividend payouts and relatively lower tax collection by the government due to the subsidy on oil. Increase in National Saving Schemes (NSS) yields and resultant rise in banks' deposit rates may divert some funds from the stock market to better yielding schemes and deposits. The market punters believe that no major change is likely in the budget, which can substantially affect the stock market. In the short run, badla, stock futures and other regulatory issues will keep the Index in a narrow band of 6700-7400 points level. Political stability coupled with double-digit earnings growth will continue to provide decent gains from investment in equities.
Positive budgetary measures are expected for the banking, textile, telecom, and cement and fertilizer sectors. Like last year, the forthcoming budget may bring negative news for the local car assemblers as government is likely to announce a reduction in import duty on completely built units (CBUs), in order to bridge the demand-supply gap. PSF is another sector, which is likely to be hurt as government may reduce PSF import duty to provide incentive to the local textile industry. We do not expect significant impact of budget on the energy sector oil marketing companies (OMCs), exploration and production (E&P), and Gas Distribution. However, independent power project (IPPs) being income stocks may come under pressure due to increase in NSS rates.
Another propping move would be a series of initial public offering (IPOs) and term finance certificates (TFCs) in private sector. Chenab Textiles, Zephyr Textiles, WorldTel, Netsole and other private sector companies would offer IPOs cumulatively of over Rs1000 million worth in the coming months. Over a period of past one year over Rs16 billion IPOs and TFCs have been successfully launched both in private and predominantly public sector.
INDICATORS OF KARACHI STOCK EXCHANGE
(Rs. In Billion)
TURNOVER OF SHARES
AGGREGATE MARKET CAPITALIZATION
Source: Corporate Division, Statistics Department
EXPOSURE OF BANKS AND DFIs IN SHARES AND BADLA FINANCING
(Rupees in million)
POSITION AS ON LAST WEEK OF MONTH
INVESTMENT IN QUOTED SHARES (AS COST)