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Cover Story

By Nadeem Naqvi
Dec 06 - 12, 1999

The recent rise in the Karachi Stock Exchange Index (KSE-100) has prompted observers to claim that the bear run in Pakistanís equity market witnessed over the last three years is coming to an end. Analysts are busy updating their reports on Pakistan with optimistic slant and market consensus is talking about the KSE-100 Index touching 1400 in the New Year or even earlier. Even technical chartists have jumped into the foray and are arguing that if the Index rises above 1290 resistance level, it is likely to move to 1400 or higher over the next quarter.

We have seen such euphoria numerous times over the past several years only to be disappointed. The KSE-100 has never successfully breached the 1400 barrier in a sustained manner ever since the spring of 1998. No wonder the layman and even the seasoned investor view the present euphoria with a healthy dose of skepticism. And rightly so. The stock market is driven by expectations related to future earnings growth, relative valuations and risk perceptions of the market. Therefore, before jumping on to the bandwagon of the optimists, it is useful and wise for the average investor to step back and assess the ground realities for a moment. Only if he or she comes to the conclusion, after due analysis, that the underlying macroeconomic, government policy stance and corporate fundamentals are expected to improve over the coming months, should the investor risk precious savings and capital in the stock market.

To apprecite how and why the Pakistan stock market behaved in the way it has it is instructive to do a quick historical scan. The following charts highlight yearend KSE-100 and BSE-30 (India) levels between 1991 and 1999 earnings growth of companies included in the indices, flow of foreign funds and average daily volumes.

Yearend Index levels

KSE-100 BSE-30

1991 1661 1909

1992 1244 2615

1993 2164 2246

1994 2049 3927

1995 1498 3110

1996 1340 3085

1997 1754 3659

1998 945 3055

Nov 1999 1247 4622

Average Daily Volume for the Year (US$m)

KSE-100 BSE-30

1991 2 88

1992 4 80

1993 6 82

1994 11 103

1995 12 83

1996 26 83

1997 46 363

1998 38 461

Nov 1999 81 1045

Average Daily Volume for the Year (US$m)

KSE-100 BSE-30

1993 70 827

1994 -15 2165

1995 16 1191

1996 56 3058

1997 63 1613

1998 16 -163

Nov 1999 -50 1188

Annual earnings growth (%)

KSE-100 BSE-30

1994 16 26

1995 4 43

1996 9 43

1997 23 10

1998 -5 18

1999F 11 18

2000F 15 22

The contrast in the behavior of KSE and the BSE especially over the last two years is stark. While the BSE recovered quickly after the nuclear tests and has gone from strength to strength, the KSE has continued to languish and become range bound. In both Pakistan and India, political instability was rife throughout the 90s decade. There were frequent changes of government in the two countries, both were subjected to international sanctions and both markets had similar infrastructure weaknesses. So why this huge disparity in funds flow even after factoring in the much larger economy of India as well as the greater breadth and depth of its stock market.

While the Indian economy is six times the size of Pakistanís economy, the foreign portfolio inflows into India have been 20-25 times larger over the past few years. In fact, during 1999 so far, India has received net foreign portfolio inflows of almost US$1.2bn while Pakistan has seen net outflows of over US$50m. The market capitalization of Pakistan stocks peaked at around US$14bn in 1994 and has trended down ever since. To some extent this is due to sharp fall of the Pak Rupee against the US$ from PRs24/$ to PRs51/$. However, valuations have also been compressed due to greater uncertainty and no large new issues have come on the market for listing over the last three years. The following chart shows how Pakistan equitiesí market capitalization has changed during the last five years.


Pakistan Stock market capitalization 1995-99

Y/e December US$bn

1995 9.0

1996 10.6

1997 11.8

1998 6.4

1999* 7.1

*Upto Dec 2, 1999


On a regional level, Pakistan marketís capitalization as a percentage of total Asian (ex-Japan) stock marketsí capitalization of US$2000bn has sunk to a miniscule figure of 0.3%. This can be contrasted with a figure of 7.8% for India, 6.3% for Malaysia, 3.0% for Indonesia, 2.3% for Thailand and 2.0% for the Philippines.

The above data highlights an important aspect which is often overlooked. While foreign portfolio investment into Pakistan equities has been an important factor in determining market performance, in absolute terms the numbers are not very large. What has happened is that the domestic investors, both institutional and retail, have pulled liquidity out of the market at an unprecedented scale over the last three years. NIT is a classic example. Up to 1994-94, NIT alone use to pump in over PRs8bn fresh funds per annum into the market. It did this both in terms of taking up 10% of any new issue as well as part of its overall investment strategy. When NIT un-fixed the value of its units and made it NAV-based in 1996/97, retail investors suffered a massive capital loss and lost faith in the instrument. Retail inflows into NIT units literally dried up as a result of which this major support to market liquidity simply disappeared.

The other major domestic source of institutional liquidity into the stock market were the Development Finance Institutions (DFIs) such as NDFC, BEL, IDBP etc. Historically, these institutions used to put in several billion rupees worth of fresh funds into the market every year. However, in the mid-1990s, there own low cost, foreign concessional financing sources reduced sharply as international development finance agencies switched funding directly to the private sector of developing countries. At the same time, financial sector reforms initiated in the mid-1990s led to large scale restructuring of DFIs operations. As a result of the above two factors these institutions turned into net sellers on the stock market from having been net buyers in the past.

While the institutional liquidity flows into the stock market fell, retail support also began diminishing. The mid-nineties was characterized by record high interest rates with returns on government sponsored savings scheme touching over 19% per annum. Small investors had already been burnt in the market after the collapse of share prices in key sectors such as cement, textiles, chemicals, power and banks. Along with the shock of NIT units loss of value this caused a major run for safety by retail investors who dumped stocks and went for guaranteed high returns of government saving schemes.

It was the combination of the above factors along-with policy inconsistencies such as the freezing of foreign currency accounts and imposition of capital controls that caused complete collapse of investor confidence. The consequences of which are with us even today. With secondary market in a bear grip, the primary market for IPOs naturally dried up. Thus, the very function of the stock market of providing long term capital to industry came to a standstill.

Question now is how can investor confidence be re-ignited and flows to the stock market attracted back. The starting point is the realization that the world today is a very different place than in 1993/94 when there was a rush of international portfolio funds into emerging stock markets. After the Far East economic crisis of mid-1997 and the Russian debt debacle of 1998, fund managers have become very cautious and choosy about which markets they allocate their assets into. There is now a much greater focus on external balances, foreign exchange reserves and of the entry and exit out of markets (i.e. lack of capital controls). Further, foreign funds are placing increasing emphasis both on macro level factors such as economic management and policy consistency as well as micro level issues including corporate disclosure governance and regulatory/market infrastructure improvements.

The above developments necessitate a major rethinking on the part of all constituencies related to the local stock market ranging from regulators stock exchange managements the brokerage industry to the financiers and domestic institutional investors. There is need for a comprehensive strategy to revive the stock market through new short term initiatives as well as longer term institutional reforms that will help in creating and enabling environment for attracting fresh investments into the market.

Measures necessary to improve stock marketís attractiveness

Some immediate measures that can have a positive impact on stock market liquidity flows and investor confidence are as follows:

Reduction in interest rates on government savings schemes.

With inflation running at 5-6%, a 16% return on National Savings Schemes (NSS) is creating a major distortion in the financial system as the asset pricing mechanism in the market has broken down. Further, there are reports that the NSS are being misused by unscrupulous elements who borrow from banks at export refinance rates using bogus documentation and then invest these funds into NSS/prize bonds. In effect, the government has enabled such people to benefit from risk free arbitrage at the expense of genuine savers, investors and taxpayers. Reducing interest rates on competing assets will make equities attractive. There are a good number of fundamentally sound scrips offering earnings yield (EPS/Price) of 12% or better.

Doing away with capital controls.

Ideally, the central bank should do away with the informal capital controls that are in place at the moment through the extremely cumbersome bureaucratic procedures brought in to vet capital repatriation. Central bankís sources have serious reservations about this as they believe that there are higher priorities in terms of foreign exchange requirements than equity market repatriations given the current level of reserves and the need to manage the value of the rupee in the interbank forex market. If this is the case, there are other alternatives which can be adopted. For example, the State Bank can create a parallel foreign exchange flow mechanism specifically for the capital markets and keep such funds in a separate escrow account rather than co-mingling them with countryís general reserves. Analysis indicates that such a system would effectively mean that there would be no capital controls to inflows and outflows of foreign funds in the stock market. This is a critical element in any initiative to rejuvenate the domestic market because a large majority of foreign funds operate under trust deeds that strictly prohibit investment in markets that have capital controls or experience excessive delays in repatriating funds. Both local and foreign analysts strongly feel that bringing in such a system would substantially improve Pakistanís chances of attracting foreign portfolio inflows.

Listing government-owned enterprises on the local exchanges

While the above two actions pertain to generating demand in the stock market, we must also realize that the depth of the market is very shallow. A cursory review of average daily volume makes it abundantly clear that 3-5 stocks command 95% of the traded volume. So, even if money is willing to come to Pakistan equities there are no new stories. Thus, it is imperative that the size of the investable universe is increased. It is estimated that listing of government-owned banks, insurance companies, energy sector entities and fertilizer plants would potentially raise Pakistanís market capitalization by anywhere between US$2-3bn. There is another crucially important reason why this route should be considered by the government. As stated above Pakistanís weight in Asia (ex-Japan) has already fallen to negligible levels. At the end Q1/2000 the weights of Malaysia and Taiwan are going to be raised in the Morgan Stanley Capital International (MSCI) Asia Ex-Japan Index. Once that happens, Pakistanís weight will literally disappear. A large number of index funds will then ignore Pakistan equities completely even when new economic policies begin to have positive impact on investor confidence. It is therefore essential that the government not ignore this important aspect in its forthcoming reform agenda.

Over the medium term there is already a policy framework prepared with the assistance of the Asian Development Bank (ADB) covering regulatory framework, institutional strengthening, infrastructure building of capital markets as well as proposals for substantially enhancing financial reporting and corporate governance etc. It is only a question of the seriousness and will to implement many of these measures. This will result in significant changes in the capital market landscape over the next 12-24 months and help make the market become attractive to both domestic and international investors.