Cover Story
Pakistan Stock Market:
Diagnosis and Suggesions |
|
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.
