The stock market pundits have started playing with the nerves of the investors, infusing different news in the local bourses that the government would impose tax on capital gains and might raise level of capital value tax.

May 29 - June 04, 2006

The KSE-100 index received heavy battering and the gains of more than 28 percent since January 1, now fizzled and clipped to just eight percent. Several companies have plunged and have lost more than 20 percent of their share values as compared to their high levels touched during the January to May period. The companies were on the losing streak was led by Oil and Gas Development, Pakistan Telecommunication Co., Pakistan Oilfields, D.G. Khan Cement, National Bank of Pakistan, MCB Bank Ltd., Lucky Cement, Maple Leaf Cement, Pakistan Petroleum Ltd., Pakistan State Oil and Bank of Punjab Ltd.

The bearish sentiment had bruised the sentiment of the investors, the turnover has depicted a downturn and as compared to hey days, means in the early part of this year, the business have fallen to almost half, i.e. about 200 million shares a day. This showed that several investors are sitting back to their positions and waiting for right moment to offload their shares. Heavy causalities have forced the financial institutions to stay away from the rings, despite the fact that several scrips have reached attractive levels and assured good returns. But topsyturvey status of the market and infiltration of negative news related to budgetary measures have became major hurdles for the financial institutions and high net worth individuals to take position in the sagging market.

Despite government announcement at the Karachi Stock Exchange last week dispelling all the reports that the government has no plan to impose any tax on share business or tax capital gains, the confidence of the general investors failed to restore. ``There's nothing in the offing that this exemption is being withdrawn,'' Habib Fakhruddin, a spokesman for the Islamabad-based Central Board of Revenue said. "We do not expect any major modification in ongoing reforms initiated since 2002 by the present government.

Since the stock market is a sensitive indicator of the economy", said a leading analyst. The government would avoid taking any harsh decision in the upcoming budget. Imposition of CVT during FY05 Budget was an attempt to bring the stock market into tax net to broaden the overall tax collection ratio. "We do not expect any upward revision in CVT and withholding tax on purchase and sale of shares respectively as the CBR authority is quite happy with the present setup with the exchanges", said Tariq Hussain Khan, research analyst at Atlas Capital Markets Ltd. As for tax on dividend income, the government may not take this issue seriously. Last but not least, exemption on Capital Gains may continue till the end of FY07. Two years ago, Capital Value Tax (CVT) was imposed at the rate of 0.01% on purchase of shares and 0.005% withholding tax on sale value of shares coupled with a presumptive tax of 0.005% on sale and purchase of shares imposed on brokers. At the same time, financiers (CFS providers) were also liable to pay 10% withholding tax on the income generated from CFS investment. This year, we do not expect any revision in any levy including CVT and withholding tax. This year too, the management of all exchanges proposed to widen the gap of corporate tax between listed and unlisted companies to at least 10 percent. This would encourage the private companies to get listed in the stock markets. Companies shy away from being listed due to stringent reporting laws applicable to listed companies and therefore any differential in tax rates would encourage private companies to convert to public limited companies.

However, this proposal is expected to go through. On the other hand, the government might repeat its previous practice to give further relaxation of 1 percent in income tax rate for fresh listings at stock exchanges. At present, dividend income is being taxed at 5 percent under withholding tax regime for public companies and insurance companies and 10 percent for all others. Until June 2002, tax on dividend from unlisted companies was 20 percent. It was a long-standing quarrel by common shareholders to eliminate this double taxation regime as it already gets deducted from the profit before taxation.

The Federation of Pakistan Chamber of Commerce & Industry (FPCCI) has demanded the exemption of a 10 percent tax on dividend income for holding company or Group Company received from its subsidiary if it has a more than 75 percent share capital of the subsidiary. However, pundits do not expect any change in this regard. During FY04 Budget, the government had extended tax exemption on Capital Gains till FY07. Every year the government has extended this exemption since 1975. The main purpose of continued extension is to promote activity in stock markets evident from the positive developments in the market. However, any announcement of imposing Capital Gains tax will be a big threat to the market. The current saving and the investment rate in the country is low. The government has taken a good step with the introduction of an investment allowance. In last year's budget the government had increased the maximum limit of the allowance from Rs 100,000 to Rs 150,000.

It is proposed to increase the ceiling of investment allowance at least up to Rs 500,000 so that the investments in equity can be further promoted, said the KSE in a letter to finance ministry.


BANKING SECTOR - Positive A spectacular performance was witnessed by the banking sector during 2005 and the first quarter of 2006. Total profits of the sector during 2005 stood at Rs 47.5 billion as against Rs 23.8 billion during 2004, up by 100 percent whereas 1Q/CY06 earnings rose by 53 percent. Improved performance emanated from an 89 percent and 85 percent increase in mark-up income during CY05 and 1Q/CY06 respectively, supported by a substantial improvement in other income and reduction in corporate tax rate. The GDP growth is expected to slow down during FY06 and FY07 to 6-7 percent compared to 8.4 percent in FY05. Nevertheless, analysts feel that this too is very reasonable. Therefore, given this growth, credit off-take is expected to continue to increase. Advances during CY05 rose by 29 percent to Rs 2.0 trillion from Rs 1.6 trillion at the end of last year, whereas during 1Q/CY06, they rose by a marginal 1 percent mainly due to a constant increase in lending rates. It was reported that investment in the textile machinery fell by 6.4 percent in May. An investment of over US$5 billion was made in the sector when interest rates were as low as 4% a few years ago. However, an over 6 percentage points increase in rates has forced the industry to reduce investment. This is evident from the fact that imports of textile machinery fell by 11% during July - April FY06. As per the government's policy, the corporate tax rate on banking sector for the next fiscal year would be reduced further by 3 percentage points to 35 percent, in line with other listed companies. The government may announce its privatization plans in the upcoming budget. With NIT being one of them, three banks with major holding of the mutual fund's units, namely NBP, BOP and Faysal Bank would be the major beneficiaries.

INSURANCE SECTOR - Positive In the year 2005, insurance industry continued to reap the benefits of sustained GDP growth and increasing economic activities, especially in industrial and consumer finance sector. The assets of insurance companies witnessed double-digit growth since CY01 with an average growth twice that of GDP growth rate. Non-life insurance sector showed a growth of 16.2 percent while a moderate growth of 6.1 percent was witnessed by reinsurance sector. Growth in assets also ensued from enhanced paid up capital requirements set by SECP, which ultimately improved the risk management capacity of insurance companies. In the Budget FY06, government allowed capital gains tax exemption of insurance companies on equities up till June 2007. The outcome of this budgetary measure was a four-fold increase in overall income earned from investments in equity markets combined with other investment in other fixed income securities and deposits. The government is expected to announce various development and infrastructure projects in the upcoming budget which will open various avenues for non-life insurance companies. Along with that any positive development in the automobile sector would bode well for the insurance sector as this segment has a share of more then 50 percent in the net premiums earned by non-life insurance sector.

CEMENT SECTOR - Positive The measures to be announced during the next fiscal year budget to have a positive impact on cement sector as the government may remove the ban on cement export. The decision on duty free cement import taken by the government put pressure on the local cement industry to reduce per bag prices that touched Rs 400 per bag a couple of months ago. Now the situation has changed entirely as cement prices have come down to under Rs300 per bag. Therefore, the government may well take back the decision. In addition, expect some incentives for construction activities in the form of (a) duty free import of construction machinery (b) a sizeable allocation of PSDP which is expected in the range of PRs340-350bn (c) construction of dams and rehabilitation of water canals (d) development works under city governments around the country. Muhammad Zeeshan Khan, research analyst at AL-Habib Capital Markets said in the budget of FY03, government reduced the central excise duty on cement from Rs 1,000 per ton to Rs 750 per ton and announced that it would be reduced by Rs 250 per ton each year bring it down to zero by FY06.

However, as per the government's opinion the cement manufacturers have not transferred this benefit to the consumers and hence aborted the reduction process leaving the CED kept at Rs 750 per ton.

Hence we do not see any reduction in this budget as well, despite the fact that currently the CED in Pakistan is comparatively higher in the region. Currently, cement sector is facing shortage of supply on the back of delay in commissioning of new lines which pushed the prices to unprecedented levels resulting in a depressed demand in the second half of the current fiscal year.

Housing sector is waiting for a reduction in prices while the government has decided to use imported cement for the development projects. We expect that cement sector's profitability by the end of FY06 will witness a significant improvement due to sky high margins. Going forward, we see a decline in profitability from FY08. Prices have started to decline but we do not see a major decline because cement manufacturers have taken heavy loans for financing its expansion projects resulting in higher financial charges which may hurt sector profitability. Our stance on the cement sector in the short term is positive but in the long term we have a negative stance. Currently cement sector is trading at 10.50x of the expected earnings of FY06 and we see upside potentials in Maple Leaf Cement, Cherat Cement and DG Khan Cement which are currently trading far below their fair values.