The market is poised for take-off.

By Umbereen Beg
Manager, Capital Markets,
American Express Bank Ltd
Nov 03 - 09, 1997

Traditionally, in Pakistan the term "Capital Markets" has always implied the equity market. Although the Companies Ordinance 1984 allowed for issue of debt securities and redeemable capital securities in Section 120, the public corporate debt market only came into existence with the issue of a Rs. 232 million Term Finance Certificate (TFC) in February 1995. The slow pace of development of the debt market in Pakistan is further highlighted by the fact that on a global level, debt markets have attracted much larger flows than the equity markets. According to a World Bank study conducted in 1994, the flow of dollars into global bond markets increased from $ 0.2 billion in 1975, to $ 5.6 billion in 1985 and $ 42.1 billion in 1993.

In light of the above, many regulatory changes were introduced to facilitate the development of the corporate debt market. Debt securities were allowed to be listed on the exchanges, which brought them up to par vis a vis equity securities and as such investments in debt securities became exempt from capital gains tax. The stamp duty rate was reduced from 4.5% to 0.15% on issue and 0.1% on subsequent transfers. A credit rating agency was also established to analyze and rank issuer's from a risk perspective, and the Corporate Law Authority has permitted provident funds to invest in listed securities, including TFCs. Nevertheless, the impact of these modifications had been minimal and the scope of the debt market remained unrealized. To date there are only four public issues of corporate debt and the aggregate size is just under Rs. 2 billion, while the outstanding public investment in government debt totaled Rs. 220.3 billion, and the equity market capitalization is Rs. 593 billion.

In the preceding few weeks, much has been done to revive the market. On the regulatory front, foreign banks have been allowed to repatriate the earnings from registered corporate debt, finally making foreign banks eligible players in the corporate debt market, a move which will significantly improve the liquidity of the market. The Central Board of Revenue has decided to exempt all rated fixed income securities from tax, effectively enhancing net returns, depending on the investor category. The State Bank has also allowed banks to provide six month forward cover for rupee denominated securities for non-resident investors, given Pakistan's constantly weakening currency, the lack of a hedge had always been a deterrent for foreign investment in corporate debt. One cannot fail to ignore the significance of these changes—the impact is already visible: the ICI TFC has moved from trading in a band of 100-100.50 to 102-102.50 in a matter of weeks. The problem now is not the lack of buyers, but the lack of sellers, although several new issues are in the pipeline.

These changes also allow American Express Bank Ltd., to expand its role in Pakistan's Capital Markets. AEB has already played an important role in developing a Commercial Paper market. In 1996 we arranged the first commercial paper issues in Pakistan for Lakson and Premier Tobacco. Structured as Short Term Finance Certificates, the papers were privately placed. The issues were very successful at the primary level, however, due to the regulations in place at the time, we were unable to make a market for it at the secondary level. In the last quarter of 1996, we also participated in the first Bankers Acceptance issue for Orix Leasing arranged by First International Investment Bank. Perhaps more significantly, we succeeded in trading the Bankers Acceptances in the secondary market, developing a considerable investor base. In 1997, we arranged the first Corporate Acceptance transaction in Pakistan for Sui Northern Gas Pipelines Ltd. The issue was very successful, not only because of its attractive return, and the fact that it was secured against SNGPL's receivables due from KAPCO, but because the tenors were so flexible. We structured the issue as a set of six bills of exchange, maturing every month, making the instrument inherently tradable.

In Pakistan, as in all economies at this stage of development, the shorter end of the market must pick up first. A volatile interest rate scenario inhibits investors from wanting to lock into a long term instrument. Similarly, higher issuing costs and longer time lags for term paper, make issuers, especially seasonal borrowers more keen to offer commercial papers. Greater depth in the short-term market will grow investor confidence regarding credit-worthiness of the issuers and liquidity of the paper, and will align costs rationally, making the term market more feasible.

For a thriving corporate debt market, an active Over the Counter (OTC) market is a necessity. To date, market makers have mostly been either local brokerage houses or investment banks, neither of which appear to have the requisite balance-sheet depth to support a serious market-making function. Foreign banks, on the other hand, have the liquidity as well as the expertise to truly create market support for corporate debt issues. Therefore, while listing is an important first step in the secondary market process, the aim really must be to encourage OTC activity. With this in mind, a post-placement listing option has been proposed to the Karachi Stock Exchange, whereby the TFCs will be privately placed, avoiding high public offering costs, but will be listed subsequently, making them eligible instruments for a wider investor base.

With renewed interest in corporate debt from both the investors' and issuers' perspectives, the market is poised for take-off. Due to the fact that the forward cover is allowed for a six month period only, the shorter term paper will be more popular, at least initially. It is only after sufficient depth has been developed in the short term commercial paper market, that the longer term TFCs market will be able to achieve its great potential.