IMF's loan approval will pave the way for the re-riding of the market

By Majid DawoodDirector
Arif Habib Securities
Nov 03 - 09, 1997

Capital markets, and especially the stock markets in Pakistan, have come a long way over the last decade. Since 1991, when the boom first resulted from the liberalisation policies of the government at the time, we have seen many major developments such as a manifold increase in the number of listed companies and the traded volumes, introduction of automated trading and settlement systems on the pattern of the world's modern stock exchanges, as well as intensifying competition for the business evident from the quality of research being published and distributed.

TRADING LIMITED TO A FEW STOCKS: Despite the increase in listings, one main problem faced by the stock market is its over-dependence on a few scrip's for a major part of its turnover. This trend has set-in in part due to the introduction of large scrip's like PTCL, Hubco and the massive rights issue by ICI. The top ten liquid stocks account for approximately 80% of the traded volumes on the average. This leaves very little room to maneuver for institutional investors for changing their portfolio allocations if the need arises. A one-off splitting of large price stocks to level these to double digits would Increase liquidity as well as reduce speculation. An increase in the number of sufficiently liquid stocks will help improve the situation.

FREQUENT DEVALUATIONS CAN BE A THREAT: Besides fuelling inflation, which is negative for equities in itself devaluation results in foreign investors losing part of the value of their holdings. intermittent devaluations can result in a loss of confidence on the part of foreign portfolio managers who might be inclined to shorten their investment horizons. This could lead to a more volatile market. Foreign fund managers, like anyone, tend to look for investments least affected by the negative impact of devaluation.

PUBLIC SECTOR DIVESTMENT WILL HELP BROADEN THE MARKET: The ongoing privatisations and divestments of the public sector corporations such as banks and utilities through the stock market will help broaden the market's base. Besides further increasing trade volumes, privatisation will likely help reduce the reliance of the market on a few stocks which currently account for most of its turnover.

ECONOMIC INDICATORS SHOWING SIGNS OF RECOVERY: For the fiscal year l997-98 Pakistan is expected to post a GDP growth rate of between 5% and 6%, which is in line with the historic long term growth rate of around 6% p.a. This is significantly better than last year's growth of about 3%. Forex reserves are constantly being maintained above the US$1 bn mark for the last six months. Bank borrowings by the government have also been kept in check up till now allowing more credit at lesser rates for the private sector. The agriculture sector — correctly considered the mainstay of Pakistan's economy — is also expected to perform better than last year. The expected cotton crop of around l0.5 m bales will likely infuse life in the textile sector. Value added textiles exports are expected to benefit from the devaluation of the, rupee.

These factors point to a general betterment in the economic situation which will likely be reflected in the stock market, it being the barometer of the economy.

IMF'S LOAN APPROVAL WILL PAVE THE WAY FOR A RE-RATING OF THE MARKET: With the expected disbursement of the first tranche of IMF's $1.6 bn loan shortly, we expect international credit rating agencies to take a more positive view of' the country's economic resilience. Approval of the loan, coupled with any improvement in sovereign credit ratings, will be a positive signal and a testament of confidence in the government's policies. This can result in a re-rating of the stock market. Foreign portfolio managers can play a major role in such a re-rating.

INCENTIVES FOR THE DEBT MARKET: The government of Pakistan has recently announced some measures to encourage the development of the local currency debt markets. The most significant among these is the complete removal of all taxes for foreign investors investing in government bonds and listed corporate debt. The instruments available to the foreign investors under this tax exemption are Short Term Federal Bonds (STFBs), Federal Investment Bonds (FIBs) and listed Term Finance Certificates (TFCs). Although investment in these instruments was allowed two years back, withholding tax on interest income was so prohibitive that no significant foreign investment was witnessed in the local currency debt market.

GOVERNMENT REMAINS THE MAJOR DEBT ISSUER The government of Pakistan is the major issuer of debt in the market with its six month bonds, the STFBs. In addition FIBs of maturities varying from 3 years to 10 years are also offered for subscription. Presently, the corporate sector seems to be a bit hesitant in coming forward and up till now only four corporations have issued their TFCs for listing ad the stock exchange.

LIQUIDITY- A CONCERN: Since corporate debt issues are so few, there is not much trading activity in the corporate debt market. All the four TFCs have mostly been purchased by investors who will likely hold them till their maturity. As new issues come on the scene, this impediment is expected to diminish.

DEBT MARKETS LIKELY TO SEE MAJOR GROWTH: The corporate sector appears to have appreciated the potential of the debt markets very recently and hence the laws governing this sector are still not well developed. With the issuance of new TFCs and the realisation of the government's serious intentions to develop a fully functional debt market, we expect a significant growth in this area in the future. The expected growth will also likely alleviate the liquidity constraints. Recent changes in the taxation regime for TFCs have already encouraged activity in the market. The demand for financing is ever-increasing. With the appreciation that debt markets can potentially provide an attractive alternative source of funds, there is very considerable room for growth over the medium term.

LOWERING OF THE EFFECTIVE TAX RATE REQUIRED: The extension in the exemption from sales tax and capital gains tax, the removal of the tax on bonus shares and the removal of the 0.5% turnover tax on investment advisors such as brokerage houses are all very commendable steps. This move will likely help in boosting the confidence of the long term investors.

NEAR TERM OUTLOOK IS GOOD: Recent past has witnessed many new instruments being introduced in Pakistan like Eurobonds, Samurai bonds and the securitisation of corporate receivables. Debt markets are much larger in size than the equity markets in many countries because of debt being a lower risk investment (as compared to equity) for the investors. For the issuers, it is attractive because debt is seldom packaged with management control. There appears to be a lot of room for expansion in this sector. So long as inflation is kept within reasonable limits, the debt markets are likely to see sustained development in the future.

With the economy expected to perform better this year, and the significant changes taking place in the stock market — e.g. the introduction of Karachi Automated Trading System KATS) and the initiation of Central Depository Company (CDC) - the added transparency help reduce the speculative element inspiring confidence in long term investors. The medium term outlook for both markets is positive.

THE FUTURE BODES WELL: Given the limitations of the banking sector, the corporate will need to turn to the debt market for their funding needs. Leasing companies mushroomed during the early 1990s due in the main to the ever increasing corporate needs for debt financing. We believe this demand to determine the direction for the market's development in the future. With the knowledge of increasing interest rates in the past and the expectations for the medium term, many corporates will prefer to lock in the current mark up rates for their medium term loans. This too will likely result in an increase in activity for debt instruments.

OPTIMIZING TAX RATES TO SUIT CAPITAL MARKET NEEDS: For the last several years, a "wealth tax" is payable by individuals whose net worth is in excess of Rs. 1 m ($22,400) the floor limit for which has not been increased despite severe erosion in the value of the rupee. The savings rate in Pakistan remains very low at 11% of the GDP. This element of the wealth tax — applied on tax paid rupees invested or saved—is a major deterrent to the development of a saving and investment culture in the country and in our view should either be removed altogether or its floor limit increased substantially.

If doing away with wealth tax altogether is not deemed suitable by the government, it should consider substituting the wealth tax with a net capital gains capital gains minus capital losses) tax chargeable at similar rates as wealth tax. Such a substitution should in turn also help reduce speculation and increase longer term investment.