CAPITAL MARKETS IN PAKISTAN
In an efficient capital market, timely flow of information gives all the Participants a fair chance to share in the potential profits
By Professor Syed Fazle Hasan
May 08 - 21, 2000
Director & Dean, Asian Management Institute, Iqra University
The primary function of securities markets is to facilitate flow of funds from having surplus liquidity to deficit units. The greater the allocative efficiency of such funds, the higher the rate of capital formation and hence the rate of economic growth.
An efficient functioning of capital markets increases the liquidity of capital assets and consequently minimizes transaction costs and improves rate of return. Both depth (size of issues) and breadth (diversity of issues) in capital markets lead to lower transaction costs. This in turn serves as an inducement to investment in financial assets.
The securities markets in Pakistan have remained under-developed due to the following reasons:
Lack of depth
Market depth requires the presence of a large number of buyers and sellers willing to buy/sell at prices above/below the prevalent levels. The share of most listed companies in Pakistan are predominantly held by:
1. Families (often accounting for 51% of total shares)
2. Institutional participants (such as ICP and NIT)
The remainder is held by public sector institutions, mutual funds and retail investors. Due to the concentration of holdings, the free float of most shares is very small. This in turn leads to illiquidity and failure of stock prices to reflect the intrinsic value of the company. The situation is even worse in the case of multi-nationals in which the parent companies routinely tend to have holdings in excess of 60%.
Lack of breadth
Pakistan's limited industrial base reduces the choices available. The herd mentality in establishing industries has resulted in over-capacity in sugar, textiles, synthetic fibre and cement. The financial sector is affected with high percentage of non-performing assets and defaults in an environment where borrowers' quality, financial health and ability to repay is increasingly suspect. Though a number of public sector companies are listed, inefficient management and fear of government using their balance sheet for its own budgetary support keeps in investors away from these companies.
Crowding out effect
Heavy government borrowing to finance successive budget deficits has severely limited the availability of credit to the private sector for capital market investments. Even the pension funds, normally the largest investors in the capital markets, are by law restricted primarily to government securities.
Low equity base of companies
The equity base in Pakistani companies has been very low ranging between 25% to 30% of the assets. Private Limited companies avoid listing because of the following reasons:
Historically, low cost debt was available from Development Finance Institutions. The cost was further subsidized if the project was based on local machinery. This made debt extremely attractive and inhibited development of large equity base.
Most of the companies are owned by large industrial groups, many of whom have adequate capital at their disposal and do not need to apply to the general public for funds.
- The management of profitable family owned entities avoids going public and share the benefits with the general public as well as open its operations to greater transparency that listing on the stock exchanges requires.
The Finance Minister has recently proposed to fix a benchmark level of paid up capital, beyond which companies will have to be listed on all Stock Exchanges. While laudable, this should be accompanied by legislation that helps avoid concentration of equity in a few hands.
Pricing of equities
Until 1993, the Karachi Stock Exchange did not allow shares of new companies to be issued at a premium. The market boom of 1994, however, saw many companies issuing shares at a premium; subject to CLA approval. Although greenfield companies (new companies) have to fulfil certain criteria in order to justify issuance of shares at a premium, experience has shown that such criteria have failed to prevent unfair practices.
A case in point is that of Pak Fibre Industries Ltd. That was allowed to issue shares at a premium in 1994. By manipulation of its results, the company was able to project a good performance prior to issuance of shares. Ever since, the company has been reporting heavy losses of Rs. 8 million in 1994, Rs. 2.4 million in first half of 1995 and Rs. 40.2 million in 1996. Currently, the matter is being investigated by the Securities and Exchange Commission. There are numerous examples of such 'experience to the rule' that have resulted in loss of credibility of the stock exchanges and regulators.
Lack of investor confidence
In an efficient capital market, timely flow of information gives all the participants a fair chance to share in the potential profits. However, there is no market in the world that enjoys absolute degree of efficiency. There is always some degree of inefficiency, which can be exploited by the insiders, and few well informed at the expense of the participants.
The degree of informational efficiency at KSE is relatively low and thus, insiders play a greater role. The general investors are deprived of a level playing field. Though the complaint is genuine, the investors themselves are not blameless. They themselves are in search of "tips" and when they mistake a rumour for news, they blame the informer and raise hue and cry about the rights of small investors. There is therefore an acute need for awareness generation and education of retail investors. This role has to be played by the securities industry itself with brokerage houses, the stock exchanges and regulators launching a coordinated effort to highlight the role equity investments can play in an individual's overall savings and investment planning.
Financial disclosure by companies
The system of financial reporting in our country is in a very primitive stage. There is an acute dearth of timely and accurate financial information. Since the valuation conducted by analysts is based on published annual reports, the lack of details in financial statements considerably reduces the usefulness of the exercise. This state of affairs also makes it difficult to make comparison among companies in the same industry.
There is a need for improvement of the government regulations governing financial reporting and the accounting profession. The existing regulations must also be reinforced.
Protection of minority interest
The dividend pay-outs by listed companies in Pakistan remain very low, which is a cause of concern for minority shareholders. For the year 1998, less than 150 of the 773 listed companies paid a cash dividend. The worst offenders in this are local groups who have been abusing the balance sheets of their companies to support other group concerns or unnecessary expansions. It is quite common to witness cash flows being used to invest in the shares of another entity or to provide low cost loans. The absence of cash dividends is then covered up by announcing bonus issued which dilute earnings and prices.
Interestingly, this is in contrast to Bangladeshi companies who regularly announce dividends. The regulatory authorities have limited investment in associated undertaking to 30% of the paid up capital and free reserves of the investing company in order to control this seepage of funds. However, companies frequently find loopholes and invest more than the stipulated amount in associated concerns.
The Central Depository System: The Central Depository System was launched in September 1997. By setting all transactions through electronic entries, the Central Depository System has eliminated physical handling and trading of fake certificates. At the same time, daily turnover has increased and immediate transfer of ownership has replaced the previous system whereby 45 days were required for delivery, settlement and transfer.
Securities and Exchange Commission: The Securities and Exchange Commission of Pakistan was formed on January 1, 1999 to replace the Corporate Law Authority. The main functions of the Securities and Exchange Commission of Pakistan according to the SECP Act are:
1. Maintain facilities and improve performance of companies and securities markets.
2. Maintain the confidence of investors in securities markets by ensuring adequate protection.
3. Achieve uniformity in performance of functions and exercise of powers.
4. Administer laws effectively with minimum procedural requirements.
5. Receive, process and store, efficiently and quickly, the documents lodged with and information filed
6. Ensure that documents and information filed with the commission are accessible to the public.
The main advantages of the Securities and Exchange Commission of Pakistan over the Corporate Law Authority are:
1. As compared to the CLA that needed the approval of the Ministry of Finance before taking action, the Securities Commission of Pakistan is an announced body.
2. The commission has been granted the power to take action on its own initiative without having to wait for a complaint to be filed.
3. The conclusion of three representatives of the public (2 chartered accountants and an investment banker) in the 5 commissioners of the Securities and Exchange Commission of Pakistan will greatly increase transparency and seek to ensure greater protection of the rights of general investors.
Since its inspection, the Securities and Exchange Commission of Pakistan has taken a number of steps to improve the efficiency of Pakistan's capital markets. Chief among these are:
issuance of show cause notices, 9 of them paid dividend while 18 have promised to do so in the near future. In the Finance Bill, the federal government decided to levy a 10% punitive tax on reserves in excess of 50% of paid up capital. Since this measure failed to exclude companies that had healthy reserves despite paying exchanges and chambers of commerce and industry. Under the new rule, public limited companies that distribute 40% of the current year's after tax profits as dividend will not be subject to this punitive tax.
The Securities and Exchange Commission of Pakistan has accepted companies' demand of allowing Treasury Stock under the Commission (Buy back of shares) Rules 1999. By buying back shares when they are being quoted below break-up value, companies can improve the market price of their shares. Although companies buying back their own shares will be allowed to cancel them, resale of Treasury Stock will not be allowed. In order to avail this facility, companies have to maintain a debt equity ratio of 40:00 and a current ratio of 1:1. In addition, other conditions for a buy back include the passing of a special resolution, a tender and availability of funds from profits available for appropriation.
So far, the Securities and Exchange Commission of Pakistan has identified 17 sick units. The next step is the preparation of a 'rehabilitation, Reconstruction or Reorganization Plan' for the concerned units. Possible measures may include removal of inefficient management, injection of funds, reduction of share capital, amalgamation of two or more units or alternation of the capital structure.
Other measures being taken by the Securities and Exchange Commission of Pakistan include the drafting of rules to curb insider trading and a new index with more equitable weightage being given to companies.
Other measures that can be taken to improve the functioning of capital markets in Pakistan are:
1. Efforts must be made to increase the depth and breadth of the market by limiting family ownership and encouraging new industries.
2. Regulations must be introduced to increase equity base from 30% to 60%. This will help in developing the corporate debt market.
3. To improve financial reporting and disclosure, more vigorous regulations are required. The accounting profession should try to improve its self-regulation.
4. Better regulation of insider trading is essential. The directors and senior executives should be required to disclose their sales and purchases on a regular basis.B
MARKET AT A GLANCE
No. of listed companies
Additional listing during the year
KSE 100 index
KSE All Shares
Listed Capital (Rs. Million)
Market Capitalization (Rs. Million)
Turnover (shares million)
Traded Value (Rs. Million)
New Listing (Rs. Million)
Right issues (Rs. Minion)
This includes PTCL capital of Rs. 5,100 million.
Source: Karachi Stock Exchange