Capital is the requirement of
commerce, industry, government and local authorities. The capital market is a medium for
the allocation of long term funds usually for the formation of capital assets. These funds
come from private investors, insurance companies, banks, pension funds arranged by issuing
houses and merchant banks.
The capital market collects funds from surplus sectors and channels it
to those who are in need of finance. Competitive forces in the capital markets form the
basis of efficient working of financial intermediation. However in the developing
countries the facility for raising industrial and commercial capital is either absent or
rudimentary in the latter.
Role of capital market
Capital market plays an important role in the economic development of
economies especially of the developing countries. Well functioning markets ensure that
both corporations and investors get or receive fair prices for their securities. This
ensures that viable projects will be financed and negative value projects will be
rejected. Most importantly, the integration of indigenous financial market into world
capital markets does accelerate the growth process.
Capital market in Pakistan helps to accelerate the rate of economic
development leading to increased production of goods and services resulting in an increase
in the per capita income. Capital market performs the following functions:
• Provides funds to the commercial banks to meet their long-term
liquidity requirements
• Provides the financial institutions the use of their funds
profitably over a longer period of time
• Promotes the safety of financial assets
• Channels the savings of people to investments, which in turn
brings about balance in demand and supply of funds
• Promotes mobility of finances
• Provides long term loans to government to finance development
project in the public sector
Capital market in Pakistan
The capital market of Pakistan is underdeveloped and narrow. It lacks
the presence of specialised institutions such as issue houses, investment banks that
undertake underwriting, promotion of new companies and marketing of securities. The types
of securities issued are also few. Government securities constitute a large portion of
volume of the capital market. Preference shares and debentures are far and few. They have
been issued by only a few industrial concerns. While ordinary shares are the most popular
type of securities, the insurance companies do invest in mortgages, industrial and
gilt-edged securities.
There is no separate bonds market in Pakistan. The commercial banks,
insurance companies, local bodies, public co-operatives, provident funds and the State
Bank hold all government securities. It is mandatory for the banks to keep certain
percentage of their assets in liquid form including unencumbered securities, i.e.
securities that are not pledged for loans. The banks consider these securities as a safe
and recommended medium of investment even though the yield on them is low. The banks can
convert their holdings of government securities into cash, by selling them to the State
Bank or they may deal in securities amongst themselves. For the small investor apart from
the relatively low profitability, a major drawback and disincentive against the holding of
the gilt edged securities is the difficulty in the disposal of such paper in time of need.
Instrument of capital market in Pakistan
There are five types of instrument available in the capital market,
namely:
• Corporate Bonds
• Federal Investment Bonds (FIB)
• Equities
Corporate bonds
They are issued by corporations to raise funds, e.g. WAPDA Bearer
Bonds. They are either registered or bearer. In case of the registered forms the name of
the purchaser is registered with the corporation and the transfer of their ownership can
be made by following the prescribed procedure.
Federal investment bonds
Federal Investment Bonds are issued by the Government of Pakistan. They
are similar to Treasury Bonds. They are issued for three different time periods:
short-term, medium-term and long-term,
(a) When the bonds can mature after 3 years they are called the
sort-term debt of the government
(b) When they mature after 5 years, they are called the medium-term
debt of the government
(c) if they mature after 10 years, they are called the long-term debt
of the government
Since they can be re-issued after the maturity of the bonds, e.g. when
a bond matures after 3 years immediately the investor gets another bond of the same
denomination and for the same length of the time period. Thus, it can be regarded as a
permanent debt of the government. The main feature of the Federal Investment Bonds
They provide a suitable outlet for the investment of funds like the
pension, provident fund and welfare funds which cannot be invested in Defence Saving
Certificates (DSCs) and National Savings Schemes (NSCs) operated by the National Saving
Centres and Post Offices
Equities
Equities are the ordinary shares of a company, especially those of a
publicly owned quoted company. Investment in equities on a stock exchange represent the
best opportunity for capital growth, although there is a high element of risk as only a
small proportion (if any) is secured. Although equities pay relatively low profit-related
dividends, unlike fixed interest securities, they are popular in times of low interest
rates or high inflation, as they tend to rise in value as the value of the money falls.
Floating new issue of equity through prospectus method is the most
popular way of raising capital by corporations. The promoters provide the details of the
proposed venture and invite subscription from the public. Equity is the channel through
which a large amount of public can participate in capital market.
Stock exchanges as participant in capital market
Stock exchange is an organised market that provides the facility of
centralised trading in Securities for the institutions as well as general public. The
investors in this market can earn or lose capital gains on their purchased securities in
addition to dividends paid by the issuing companies. The stock exchanges today form an
integral part of a country's capital market. They are important for capital formation as
they create marketability for the initially issued securities by providing a secondary
market for trading.
A stable and well regulated stock market enables those in need of
capital to conveniently raise their finances from small savers with the expectations that
the latter can make attractive gains by selling, their securities in the stock exchanges.
The selling and buying activity in the secondary market keeps this process going on which
helps now investors to raise money by issuing securities.
Stock exchanges in Pakistan
Stock exchanges in Pakistan form an important part of capital market.
The stock markets in Pakistan have come a long way over the last decade. Since 1991, when
the boom first resulted from the liberalization policies of the government, many major
developments have occurred, namely, manifold increase in the number of listed companies,
increase in the trading volumes, introduction of automated trading and settlement systems
on the pattern of the world's modern stock exchanges.
Opening capital market to the world
A country that erects barriers to international participation will face
a higher cost of capital. It also discourages domestic investment and diminishes foreign
direct investment. World Bank analysis indicates that Pakistan's cost of equity capital
could be lowered if an aggressive programme is undertaken to increase the degree of
integration in world capital markets.
However opening of capital market to the world without any restriction
has its own caveat and risks. Southeast crises of Malaysian and Indonesian market is a
case in the point where the fund managers destabilized the local capital markets.
Foreign investments in Pakistan
With a view to attracting foreign investors, the government has taken
important decisions and several bold steps whereby a number of controls and restrictions,
which had characterised the exchange control regime for a long time, have been removed.
The laws relating to corporate regulation have been reviewed and revamped to update the
regulations and bring them at par with the international standards. Some of the measures
taken in the realm of incentives for the foreign investors are enumerated below:
• Foreigners and overseas Pakistanis are now allowed to make new
investments without any prior approval except in a few specified industries
• Ownership of 100 percent of equity
• Ability to negotiate the terms and conditions of foreign
currency loans without any government intervention
• Decision on the terms and level of technology transfer
• Full repatriability of capital invested as well as any
appreciation
The record of actual foreign investment figures shown in the Table 1
below for the period l994 to l998 does not reflect any clear trend in the quantum of
foreign investments. The foreign investment during l994-95 and 1995-96 peaked but dropped
to a greatly reduced level in 1996-97 and 1997-98.
Foreign Investment in Pakistan
Year Amount US$ (millions)
1993-94 642.7
1994-95 1532
1995-96 1306.7
1996-97 949.5
1997-98 822.6
Source. State Bank of Pakistan
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.
Near term outlook of capital market
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.
The cost of investing in Pakistan is quite high and it does not make
much economic sense in the current conditions.
From the issuer's perspective the cost would include the basic
government rate coupled with approximately 2 percent on top of that to woo investors and
then about 1-2.5% which would be their fees. This would come to approximately l8%, which
is a very high rate. In other words anyone borrowing at this rate would have to make at
least 24% on the project which is not a very common return. Thus this would not make
economic sense to too many investors. If prospective investors were to invest in foreign
debt, the cost would come to LABOR (London Inter-bank Overnight Rate) with forward cover
and the arrangement fee added.
This automatically jacks up the cost of capital for the project which
means that the required rate of return or needed return on equity or say even return on
capital and equity becomes very high for any project to be economically viable.
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.
Public sector disinvestment
The ongoing privatisation and divestment of the public sector
corporations such as banks and utilities through the stock market will help broaden the
markets base. Besides further increasing trade volumes, privatisation will likely help in
reducing the reliance of the market on a few stocks, which currently account for most of
its turnover.
Lowering of the effective tax rate
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 percent turnover tax on
investment advisors such as brokerage houses are all very commendable steps incorporated
in 1999-2000 budget. This move will likely help in boosting the confidence of the
long-term investors.
Optimising tax rates to suit capital market needs
The savings rate in Pakistan remains very low at 11 percent 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 to be increased
substantially.
If doing away with wealth tax altogether is not deemed suitable by the
government, it should consider substituting the wealth tax with net capital gains which
means (capital gains minus capital losses) tax chargeable at similar rates as wealth tax.
Such a substitution should in turn also help to reduce speculation and increase long-term
investment.
