MOUNTING TURBULENCE IN CAPITAL MARKETS

FOZIA ISHAQUE (fozia.ishaque@hotmail.com)
Nov 03 - 09, 2008

Pakistan capital and financial markets are in a state of panic in the wake of precipitously falling value of scrip and dropping market capitalization. The current plunge began in mid April. On April 18, 2008 the KSE-100 index reached 15,676; since then it has fallen by more than 40%. In a bid to save the investors and members from the expected default, owing to the continued recession and crisis in the share market, on August 28, after a 36% fall from the beginning of the year the Karachi Stock Exchange imposed floor at 9,144 points. This floor was to be removed on October 27, however the board of KSE announced to keep the price freeze mechanism in the shares of more than 650 financial companies, at least until after the government pumps promised funds into the stock market to bailout the trapped investors in continuous funding system market and picking up shares pledged with the banks.

Extension in the 'floor' under the KSE 100-share index for indefinite period is meant to forestall possible panic-selling by the foreigners. Moreover, Pakistan's worsening economic situation, with depleting foreign exchange reserves, downgrading of sovereign debt rating by S&P to B from B+ in May 2008 and 21% depreciation of the Pak rupee so far in 2008 have compounded worries. The recent price floor mechanism has further affected confidence of foreigners who still hold shares worth $2.3 billion (25% of the market free float).

Government has been contemplating a bailout package of Rs 30 billion to foreign investors as "put option". However it is generally believed that it will actually rescue six or seven main brokerage houses, who have set up foreign offshore companies and who bring their own black money into the market as foreign investors. The withdrawal of foreign investment initiated from the onset of this year and triggered further with full pace despite the imposition of price floor as the foreign investors ejected $574 million from the equity markets in only three and a half months from July to October amid unprecedented global financial crisis, increasing insecurity in the tribal belt of the country coupled with local economic meltdown. A major outflow of portfolio investment had been recorded from the USA, United Kingdom, Switzerland, Singapore, Hong Kong and Australia. According to the SBP data, the USA investors withdrew $326 million, UK $102m, Switzerland$ 58m, Singapore$20m, Hong Kong $41m, and Australia $14m.

It is not a proper time to go into the merits and demerits of the extension of floor under the KSE 100-share index, but one thing is clear that it allowed the market to absorb the fallout of Moody's current downgrading of Pakistan bonds from plus-3 to plus-2. Pakistan is not the only country that has suffered a major set back in the value of its stock markets. There are several other countries that are in a similar situation. There are seven countries that have seen the value of their stock markets decline by more than 30% in 2008.

CAUSES OF MELTDOWN:

There are numerous reasons that have put pressure on the performance of the bourse. The most evident and obvious element behind capital markets decline is that the investors have lost confidence in the future of the Pakistani economy because of political uncertainty. To the political pressures playing on the market we should also add factors such as the perceptions about the country's medium-term economic prospects, fiscal and other policies that allow speculation, and the increase in the price of oil that has severely affected the state of the economy.

Our capital markets experienced boom during last couple of year which was primarily caused by speculation. In Pakistan's case, speculative behavior had a multiple of causes including a fiscal system that did not punish speculation (Pakistan is one of the few large economies that does not tax capital gains), it is physically close to a number of countries with large amounts of investible capital, there was an impression that the country may have finally found a way of climbing on to the trajectory of growth taken by a number of large Asian economies. It also seemed like a good investment bet.

Those who closely watch the activities of Pakistani stock market linked this huge out flow with deteriorating law and order situation, economic weaknesses, like dwindling forex reserves, which dipped down $8 billion, devaluation of rupee against US dollar, crossing Rs86 coupled with the unprecedented financial turmoil in the US, which sent shock waves to all other leading capital markets of the globe.

The failure to achieve any breakthrough to reassure the confidence of battered investors has sent bad signal to the foreign investment. In addition to this, fears of foreign investors and local investors mounted following the meetings between both regulators, they realized that government was not in position to pump a single penny in the stock market and all demands of the stock brokers met with refusal.

GLOBAL PERSPECTIVE:

America's financial system is undergoing a historical bad patch. This disorder has created a liquidity crunch and sent global capital markets spiral downward. Although apparently there are no direct fall outs of this flux for Pakistan, there may be serious implications in the long run. The financial meltdown may slow down the much needed foreign capital inflows, and significantly affect the chances for Pakistan - already struggling with the widening trade gap and current account deficit as well as sliding rupee and dwindling foreign exchange reserves - to raise commercial debt from the international financial markets. We may not face any direct consequences of the crisis. But if the financial turmoil triggers an economic slowdown or recession in America, our exports to it are likely to suffer hugely. Since large investment banks are in trouble, we do not see global funds returning to our capital market in the near term. It will weaken their appetite for risky investments in Pakistan, which is being viewed as politically and economically unstable

REMEDIAL MEASURES:

Injection of massive amounts of funds may not be the only solution to the current impasse. Its future direction is essentially linked to how the shattered confidence of investors, who have already lost millions of rupees in the bargain since the recession started, is restored. The country is in a need of an immediate cash flow to clear its foreign debt and support its economic plan but so far there is no positive signal from any of the friends. The current sluggishness in the share market is partly based on the financial situation and partly the freeze on the index. Some actions are being contemplated such as persuading cash rich companies to buy back their shares. However this attempt is likely to give a temporary relief. Adopting legislation that would lead to the de-mutualisation of the ownership of the stock markets is another probable option which is a structural change to help the operations of the market in the long run. It is also imperative to adopt policies holding back on the changes in the fiscal stance to discourage speculation. It would retain a seriously distorting element in the way the country has been managing the economy.

However the news from the corporate front is fairly encouraging as interim working results pouring in bulk indicate that overall performance of this sector is on the higher side. Some analysts feel that if the floor under the index is removed, the strength of the corporate sector could push the market higher from the current lows as investors will opt for selective short-covering at the current lower rates.

CONCLUSION:

Ultimately it is the level of confidence in the country's economic future that will stabilize the capital markets. The confidence level can only be restored by persuading prospective investor regarding competence of policy makers and regulators. This revival will allure the capital back in our economy leading to a turn around in the medium run. The yield, at 7%, available in the Pakistani market is the highest among those countries that are experiencing falls in equity prices. This level of yield will bring capital back once confidence returns.