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Economic Development via Capital Market

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Mar 06 - 12, 2000

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 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.