THE STOCK MARKET PERFORMANCE AND THE ECONOMY: THE CASE OF PAKISTAN

"A stable and well-regulated equity market is necessary to enhance economic activities among financial elements"

ABDUL RASHID, M. Phil in Economics
Institute of Business Management,

Oct 02 - Oct 08, 2006

This document is an attempt to evaluate the performance and the contribution of Karachi Stock Exchange (KSE) in economic growth of the country. The market has generally been among the best performing market. Almost all the indicators viz. market capitalization, trading volume and the market index have shown phenomenon growth. The question between the lines is that whether KSE is playing somewhat critically role to enhance the economic growth rate. First, let me say a little about the theoretical role of equity market in economic growth and then about the development of the equity market in Pakistan and finally I will present and discuss the descriptive statistics and correlation coefficients to explore the relations between stock market performance and four key macro-variables viz. exchange rate, interest rate, Consumer Price Index (CPI), and Manufacturing Output Index over the period from June 1994 to March 2005.

The equity market is a place where the shares in publicly owned companies are traded. The equity market, like many other financial intermediaries, facilitates transfer funds from surplus spenders (savers) to deficit spending (investors). The equity market thus mobilizes and channels idle resources in the economy to most productive use leading to efficient allocation of capital. A stable and well-regulated equity market is necessary to enhance economic activities among financial elements. If equity market is efficient then firms can easily raise funds by issuing securities. Stock exchange is expected to accelerate economic growth by increasing liquidity of financial assets, making global risk diversification easier for investors, promoting wiser investment decisions based on available information, forcing corporate managers to work harder to increase the wealth of shareholders, attracting foreign portfolio investment and channeling more savings to corporations in the more effective way.

An efficient and well-functioning equity market may facilitate the economic growth and development process in an economy through the following means: (1) Augmentation of household saving, (2) Efficient allocation of investment resources, and (3) Alluring foreign portfolio investment. The stock market encourages households to save and invest in financial instruments on one hand and on the other hand provides easy financing to those firms who need long-term capital for investment projects. The stock market thus channels funds from savers to investors with higher efficiency. Analogously, a well-established equity market attracts foreign investors. Foreign portfolio investment inflows raise the share prices up and reduce the cost of capital to corporations of the domestic country via lowering the price-earning ratio.

Moreover, an efficient pricing process rewards well-managed and profitable firms by highly valuing their shares. It lowers the cost of capital for such firms. A reduction in the cost of capital leads to great and better allocation of resources in the economy through channelisation of funds to well-managed and profitable firms in corporation to unprofitable and unsuccessful firms.

Now let me turn to the development of the equity market in Pakistan . There are three Stock Exchanges presently exist in Pakistan viz. Karachi Stock Exchange, Lahore Stock Exchange and Islamabad Stock Exchange. The Karachi Stock Exchange is the first Stock Exchange Market in Pakistan , established on 18th September 1947 . The Karachi Stock Exchange is the biggest and main center of trading activities in Pakistan . Approximately 80% of total current trading activities are performed in the Karachi Stock Exchange (This percentage is calculated based on turnover of shares in 2004-05, source: Pakistan Economic Survey).

In 1947, only 13 companies were listed in the Karachi Stock Exchange. However, with the development of the industrial base in Pakistan, the numbers of listed companies gradually increased to 69 in 1959. The setup of the Bonus Vouchers Scheme, the National Investment Trust (NIT), an open-end mutual fund, the Investment Corporation of Pakistan, the Security and Exchange ordinance of 1964 and Security and the Exchange Rules in 1970 provided the fundamental facilities to enhance the trading activities in Pakistan.

The stock market considerably improved during 1990s and the number of listed companies increased to 760 in 2001. In 1991, the market was opened to international investors with many other measures that were taken to liberalize as well globalize the economy. The market performance significantly improved during 1991 owing to inflow of foreign capital through the Common-Wealth Equity Fund, the Pakistan Fund, and the Lyonnaisee Pakistan Growth Fund and the market ranked the third best market in the world. Almost all indicators, for example number of listing companies, market capitalization, turnover, value traded, etc, gone up. Regrettably, the market could not maintain this growing trend in later years because of domestic economic and internal political instability and the Market index (KSE-100 Index) fell down 20 per cent in 1992-93. However, the KSE-100 Index rose by 93 per cent in next year as compared to previous fiscal year (source: SBP).

During next four years, a number of adverse domestic factors i.e., freezing of foreign currency accounts, poor performance of the corporate sector, closer of a large number of industrial units, frequent devaluation of Pakistani currency, political uncertainty etc were responsible of the poor performance of Pakistan's stock markets. In addition to this, some external factors among others included imposition of economic sanctions by leading industrial countries and unresolved dispute with the Independent Power Projects (IPPs) have an adverse effect on stock markets during the same period.

However, during 1990s, overall a number of positive development including the decline in interest rates, the removal of economic sanctions, and the trade concessions changed the environment altogether and led to the resurgence in the equity market. Moreover, in order to stimulate trading activities, the Securities and Exchange Commission has taken some prudent steps to encourage investors and discourage the cartel of the brokers. Therefore, the turnover of shares on the stock market has increased from Rs.1.0 billion in 1991-92 to Rs.67.6 billion in 1999-2000. Aggregate market capitalization has increased from Rs.218.4 billion in 1991-92 to Rs.392 billion in 1999-2000 a rise of 79.5 percent. The index increased from 1273.1 at the end of 2001 to 2701.4 (about 112.2 per cent) in 2002. Overall, the market index has gone up about more than 80 per cent over the span from 1995-2002 (source: SBP).

This upward trend continued and Karachi Stock Market achieved new heights by creating many new records during the up coming three fiscal years. For example, in the fiscal year 2004-05, 15 new companies listed their shares worth Rs.26.06 billion on the KSE. The KSE ranked as one of the "best performing stock market" among some of the top equity markets of the world in 2005. The KSE-100 Index crossed the barrier of 12000 points for the first time in the history of capital market and touched all time high on April 13, 2006. Currently, according to Pakistan Economic Survey, KSE's market capitalization is equivalent to about 44.3 per cent of GDP of 2005-06.

To shed the light on the relation between stock market performance and macro-variables (economic growth), the descriptive statistics and correlation coefficients are presented in Table 1 and Table 2, respectively. In May 28, 1998, Pakistan conducted nuclear tests. The performance of stock market and the health of the economy were unsympathetically affected by the nuclear tests. Therefore, there is possibility a one-time permanent change in nature of the relationship between stock prices and macro-variables. Thus, I divided the entire period into two sub-periods: pre-nuclear tests and post-nuclear tests periods.

It can be observed from Table 1 that the mean of all the variables almost are same during the both periods except the market rate of interest. The monthly average rate of interest has significantly been decreased relatively during the post-nuclear test period. The KSE-100 Index is more volatile during the post-nuclear tests period than the pre-nuclear tests period. Analogously, during the post-nuclear tests period, the rate of interest and the index of manufacturing out are modestly volatile relative to the pre-nuclear tests period.

Table 1
Descriptive Statistics for Before and After Nuclear Tests*

Variables

Pre-Nuclear Tests Period
(48 observations)

Post-Nuclear Tests Period
(82 observations)
 

KSEI

NEX

MIR

CPI

MOI

KSEI

NEX

MIR

CPI

MOI

Mean

4.99

3.59

2.41

4.34

4.49

4.90

4.02

1.62

4.65

4.75

Std. Dev.

0.15

0.14

0.29

0.12

0.18

0.49

0.10

0.71

0.08

0.23

Skewness

0.47

0.14

-0.62

-0.16

0.50

0.89

-0.89

-0.80

0.41

0.20

Kurtosis

2.59

1.52

3.14

1.75

1.90

2.34

2.64

2.93

2.42

2.04

*All the variables are in natural logarithm form
KSEI = KSE-100 Index, NEX = Exchange Rate, MIR = Market Rate of Interest, CPI = Consumer Price Index, and MOI = Manufacturing Output Index.

The size of kurtosis for all the said variables is less than three apart from the market rate of interest during the pre-nuclear tests period. It implies that the variables do not follow normal distribution. During the post-nuclear tests period, although the magnitude of kurtosis has significantly improved yet it is less than three.

Table 2 is providing some fascinating information about the relationship among the variables. The relationship has considerably been changed during the post-nuclear tests period. The KSE-100 Index and nominal exchange rate were negative correlated with a coefficient of -0.87 during the pre-nuclear tests period. In contrast, the both variables moved in same direction during the post-nuclear tests period. However, the coefficient of correlation (with a magnitude 0.37) is smaller in absolute value than pre-nuclear tests period. Similarly, the KSE-100 Index and the Consumer Price Index were negatively correlated during the pre-nuclear tests period and are positively correlated during the post-nuclear tests period. It means that an increase (decrease) stock prices leads to an increase (decrease) in inflation rate. However, the KSE-100 Index is negatively correlated with the rate of interest during the both periods. It implies that at low level of market interest rate the financial investor are willing to invest more in stocks as compared to at high market interest rate. This finding seems rational because low interest rate is (was) one of the major reasons behind the marvelous performance of KSE.

If we look at the correlation coefficient of the KSE-100 Index and the Manufacturing Output Indices we will find that it has been increased from 0.57 to 0.71 during the post-nuclear period. It is showing that change in industrial output is more sensitive with respect to change in stock prices during the second period. The positive magnitude of the coefficient suggests that stock market performance has positive impact on manufacturing output.

Table 2
Correlation Coefficients

Variables

Pre-Nuclear Tests Period
(48 observations)
Post-Nuclear Tests Period
(82 observations)
 

CPI

NEX

KXEI

MIR

CPI

MOI

MIR

KSEI

NEX

0.97

     

0.68

0.40

-0.25

0.37

KSEI

-0.92

-0.87

   

0.89

0.71

-0.68

 

MIR

0.35

0.33

-0.37

 

-0.57

-0.53

   

MOI

0.30

0.30

-0.28

0.57

0.74

     

KSEI = KSE-100 Index, NEX = Exchange Rate, MIR = Market Rate of Interest, CPI = Consumer Price Index, and MOI = Manufacturing Output Index.

Moreover, it is interesting to note that the correlation between price level and the rate of interest is negative during the post-nuclear tests period that was positive during the pre-nuclear tests period. However, the manufacturing output is positively influenced by the price level during the pre-nuclear tests and the post-nuclear tests period as well. It can be observed that the coefficient of correlation is higher with a magnitude of 0.74 during the latter period than the former. The coefficients of correlation are providing some evidence of the dynamic interactions between stock prices and the said macro-variables. This evidence suggests that the speed of the economic activities (and hence economic growth) can be boosted by taking some measures that are necessary for a stable and well-regulated equity market.

Despite the relationship between the macro-economic variable and stock prices, one should keep in mind that the dynamics (ups and downs) in KSE depend on a few top companies. For instance, top 5 companies viz. OGDC, PTCL, NBP, PPL and MCB, have almost 49 per cent weightage in KSE-100 Index. Similarly, only one scrip namely OGDC, has the highest market capitalization that is 21.11 per cent of the total KSE-100 Index capitalization. If we look the overall market the situation is more alarming, the market capitalization of only four sectors, fuel and energy, banks and other financial institutes, transport and communications and cotton and textiles, is about 82 per cent of the aggregate market capitalization.

In conclusion, the analysis suggests that care should be taken in designing government policies (economic liberalization, privatization, relaxation of foreign exchange control and in particular monetary policy) since the stock prices, exchange rate, interest rate and consumer prices are closely linked. They should be designed in such a way that on the one hand; they should accord to the requirements of the well-functioning equity market. On the other hand, they should provide a weighing scale in financial mechanism that would be useful in controlling any crisis (or unusual fluctuations) occurring in the financial markets, particularly in capital market. The Securities and Exchange Commission of Pakistan should start a capital market reform program at priority basis towards the development of a modern and efficient corporate sector and capital market, based on sound regulatory principles that provide momentum for high and steady economic growth. There is need to do more in the fields of risk management (for instance, introduction and application of financial derivatives), governance, transparency and of course in future trading mechanism.

Mail: arahmad_pk@yahoo.com