LONG-TERM CAPITAL NEEDS BEING SERVED BY STOCK MARKET THRU IPOS

Interview: Nadeem Naqvi, CEO AKD Securities Pvt Ltd

AMANULLAH BASHAR
Apr 23 - 29, 2007

Nadeem Naqvi, having over 25 years' experience in the international financial services industry, has worked in New York, London, Bahrain, Karachi and Toronto prior to joining AKD Securities.

Nadeem Naqvi was a Principal and Director of Invest Logy Inc, a US-based independent research firm ranked 3rd out of 300 US independent research firms by Business Week Magazine in July 2004. He also headed the domestic advisory team of Morgan Stanley's Pakistan Investment Fund and was an Executive Director at Khadim Ali Shah Bokhari (KASB) and Head of Myrill Lynch Pakistan Research team. He had advised the Karachi Stock Exchange as a former member of the Derivates Committee and Prevention of Insider Trading Committee. He was also a member of the capital market sub-committee of the President of Pakistan Economic Advisory Committee. Naqvi is an MBA in Finance from the City University Business School, London, and is a member of CFA Institute, Toronto Society.

On the back of his experience and impressive professional career and his exposure to the national capital market, Naqvi outlined the overall economic scenario and the role of the capital market in providing long-term capital to various segments of the economy.

He says capital market serves large industries like cement and fertilizer and is available for investment via Initial Public Offering (IPO); putting all this together, the role of capital market is to use the surplus savings of the economy via the capital market which is most productive sector of the economy.

DEVELOPMENT FINANCIAL INSTITUTIONS (DFIS)

We used to have development financial institutions with bureaucratic organizations, which were funded by the World Bank, government and the ADB. There happens to be no accountability of these institutions in terms of project success or where the funds went or what the return was because the money was given by someone else while the bureaucracy has to do its own work thus the project fails as success was nobody's headache,

One of the major factors for the demise of DFI was that there was no accountability of the bureaucrats and therefore they did not work; market is the best accountability for everything. Currently, there is no DFI in functional terms in Pakistan. Actually, the long term capital needs of the economy are served by the stock market or the capital market by channeling or putting those savings to the most productive and most potentially profitable sectors of the economy. However this does not mean that there is no role for a DFI because it is always a certain anchor fundamental structure investment.

Globally the role of DFI is more socially oriented - health, education, etc. You have global funds for putting money in for social infrastructure whether it is highways, bridges, dams, electricity, sewerage or mass transit systems - all of them coming out of private capital.

IPO

The private capital only comes in when there is an underlined guaranty by the government agencies because normally these things are not immediately profitable. They are very long lead dimension, say seven to 10 years before the cash flow starts. So no body is going to put the money for such a period, for he does not know what return he may be getting, thus they require minimum guarantee for returns. That is why we see this phenomenon in Pakistan as elsewhere in the world. For example, when large power projects are initiated they are put under a certain guarantee as required by the investors. Similarly, for hydel and coal development projects, we have alternative energy boards which have given a tariff of 9.4 percent per kWh for people putting windmills, solar panels, geo thermal panels; so the government has to play that role. Once that minimum guarantee return is set, then the capital market takes over in a sense that first the biggest risk is taken by the private equity people. Once the project is on line it starts producing the cash flow then they do offer IPO and the IPO distributes the risk to a large number of smaller and minority shareholders. In order to function in its most efficient form we need a couple of things. First of all we need a strong regulatory environment which ensures that there is no hanky panky in putting the original IPO document; it is actually telling the truth as what is the potential of this project. Second is the strong accounting and governance regime which is strictly followed and in case it is not followed there are real stringent penalties. Third is a culture where the capitalist is willing to share the equity stakes with others. When these things are present then the IPO market and the capital market can perform the function in the real sense for providing long-term capital.

STOCK MARKET

The capital market did well in Pakistan, however, over a period of time we have seen that in Pakistan the actual free float of the market which minority shares, the participation was very small. That has happened because of the poor having unwilling to let go of the large amount of equity holding.

An average company today, outside the multinational and government, directly or via friends and associates and relatives controls 70 to 80 percent of the shares' outstanding. Only 30 percent is left there - out of that 30 percent it is divided between long-term institutional investors like NIT, Pension Fund, Investment companies and retail investors. As a result, the liquidity in the market is much less than what it should be. Because the liquidity is less, the entire focus of the market is on top 20 stocks of the day. Out of the 600-plus stocks listed, nobody is really interested in doing research in following those stocks or investing stocks; 550 stocks just lying idle there because they were floated. As a result, the stock market's real function of providing long-term capital to the economy of Pakistan is not really happening. So, something has to change in order to make the capital markets efficient to actually fulfill the objectives of why they were set up.

Naqvi feels the first thing that is required is that the capital market regime has to itself become very forward looking so that there are new products and innovations that can allow various sectors of the economy to participate in the capital market. He suggested that there should be an over-the-counters market for smaller companies, which do not have to follow so many regulations for listing. There should be fewer regulations, which should not scare them, but there are people who are willing to be listed so at least they should be given the opportunity. There should be a special counter for technology companies because they are special groups. There should be a serious focus to bring in the derivatives markets to Pakistan.

We have been talking about derivatives markets for two years, I was on the first committee of derivatives in Karachi Stock Exchange but that is still being talked. We need to have proper Futures and Auctions Trading in our markets. Giving the reasons for this future and auction trading, Naqvi said that at the moment our future market is not an efficient market; it is actually a forward market. Elaborating his point of view, he said a future market is known as standard contracts, exchanging trade at cash settlement. They never take delivery, while a forward market is one where you take delivery.

The difference is that in a forward market when you have to take delivery you have to go through the complete settlement cycle. Where you have to put in money then again take that money out and then redeploy that money; it is a very inefficient system and we have to take a lot of liquidity to support that because it just spots except when it is for one week, one month or three month process which has to repeat itself. Proper cash settle future is that you simply take the difference of either profit or the loss to the exchange and the party concerned. It allows the futures market to grow much larger and the speculation that we see in the spot market becomes reduced and it moves to futures market, however, speculations would always be there in a way. There are two types of speculations - one is a good speculation and the other is the bad speculation. A good speculation is that whereby certain rules are set and everybody has to play by that rules and within the parameters of that rules you can speculate. What is bad one is where rules are not there - poor ethics - there is a constant amount of irregularities going on and people take advantage of advance information, whether insider trading and these are the bad part of speculations.

ECONOMY

Naqvi was of the view that our economy has entered a high growth phase, which increasingly appears to be sustainable. With the GDP growth of around 7 percent, the size of the economy should move from current $135 billion to over $224 in financial year 2012, while this growth should also be reflected by trickling down effect on per capita GDP from $846 in 2006 to $1585 in 2012 - assuming a 2 percent annual growth in population, estimated at 156 million at present. As a result, the middle to lower middle-income groups in Pakistan should also grow substantially over the next five years versus its relatively narrow base historically.