0
The capital market reforms were launched in May 1997, but did not take off immediately. For their effective implementation, an agreement was signed by Pakistan with the Asian Development Bank (ADB) in January 1998 to provide financial and technical assistance for the programme.
The following broad objectives were to be achieved with the assistance of the ADB.
* creating a policy environment for enhancing competition and level playing;
* strengthening the regulation, governance, and supervision of the securities market to restore investor confidence;
* modernizing and upgrading the securities market infrastructure for encouraging automated and centralized trading, clearing, and settlement of transactions;
* developing corporate debt market and the leading industry;
* reforming the mutual fund industry;
* promoting contractual savings through reforms of the insurance sector and pension and provident fund industry.
SECP: The agreement included setting up of a securities and exchange commission to help implement the reforms. The existing Corporate Law Authority (CLA) did not possess the capability and infrastructure to carry out such reforms.
The SECP was set up on 1st January 1999. Under the 1997 Act, the SECP has been vested with adequate operational, administrative, and financial autonomy to enable it to perform its functions effectively. Its functions include regulation of all aspects of the capital market.
In view of its statutory functions, the SECP was designated the agency responsible for implementing the reforms agreed upon between Pakistan and the ADB.
Implementation: After initial difficulties, the SECP was able to introduce a number of reforms during the last four years (1999-2002), as agreed between Pakistan and the ADB. The reform measures have been analyzed in the following paragraphs.
AUTOMATED TRADING: Open out-cry system has been abolished at the three stock exchanges and automated trading has been introduced. Trading through the internet has also been initiated and, by 31st December 02, the Lahore Stock Exchange (LSE) was conducting 20 per cent of its trading through the internet. The SECP has permitted a company in February 2003 to set up an electronic stock exchange where transactions will be conducted through the internet. However many protests have been registered against the non-transparent manner in which the permission was given by the SECP to a single party.
MEASURES: In order to minimize ‘conflict of interest’, and to bring in transparency, 40 per cent of directors on stock exchange boards will be from outside, and nominated by SECP. This is a good measure. However, a scrutiny of the nominations made by the SECP reveals that the objectives for which this decision was taken may not be achieved.
Nominating functionaries of financial institutions and chartered accountancy firms may not ensure against ‘conflict of interest. The lessons learnt from Enron and World.Com should not be forgotten. It would have been more purposeful if persons from neutral bodies such as universities and research institutes were nominated. This would not only ensure against conflict of interest, but also bring to bear fresh knowledge of finance on the decisions taken by the stock exchange boards.
Appointment and removal of managing director of stock exchange is to be made with the approval of the SECP. Moreover, no operating authority can be delegated to any director other than the managing director. This measure would go a long way in ensuring professional and independent management of stock exchanges.
RISK MANAGEMENT: Net capital balance requirement has been enhanced by 10 times, in line with internationally accepted norms. Minimum capital is to increase to Rs2.5 million for the KSE brokers and to Rs2 million for other exchange brokers from the current Rs25,000. The KSE allowed brokers to carry an exposure of Rs50 million free of cost. Free exposure limit has been abolished. Exposure limit up to Rs50 million will require a 5 percent deposit. ‘Blank selling’ is no longer allowed. These measures would increase investor confidence and lead to genuine sales, discouraging speculation and over-exposure.
The system of T+3 has been introduced, instead of the five-day trading cycle with settlement on the 10th day. This would lead to smooth business settlements. However, the goal in the near future should be T+1, or even straight through processing (STP).
CDS: Creation of a central depository system was also a requirement of the reform measures. With manifold increase in trading volumes in the 1 990s, the physical handling of paper certificates became laborious and time consuming. Custody and safe keeping of paper certificates required maintenance of vaults by the individuals and institutions, and the physical settlement was no longer feasible. Long and cumbersome share transfer procedure took up to 45 days.
The CDC has greatly reduced workload due to paperless settlement. It allows instantaneous transfer of shares without payment of stamp duty. It has resulted in substantial reduction in time and capital investments.
The CDC has introduced “delivery versus payment (DVP)”settlement system. The DVP is the international settlement standard which involves the simultaneous and irrevocable exchange of cash and securities. The CDC has also asked the State Bank of Pakistan (SBP) to give approval to make government securities scripless and have all of them listed on its system. The SBP has given the CDC permission to start work on this project.
NCSS: The National Clearing and Settlement System is an electronic system developed to replace the individual clearing houses operated in each of the three stock exchanges by a single entity. The consolidated clearing house is located at Karachi, with sub-offices at Lahore and Islamabad. Under the NCSS, continuous net settlement ((CNS) would be the main settlement option available to settle trades/transactions received from different sources. In CNS, clearing members would be required to settle only with the clearing house rather the counter party, which would minimize the risk of default.
REGULATORY REFORMS: The SECP has introduced rules for brokers and agents’ registration. Similarly, rules regarding share transfer agents, underwriters, balloters, and ‘consultants to the issue’ were introduced to help regulate the affairs of stock market and its participants, provided they are implemented in letter and spirit.
Rules for inspection of books and records by the members of stock exchange were also introduced to ensure transparency in the affairs of stock exchanges. The companies share capital (variation in rights and privileges) rules were also introduced to help bring to stock markets varied forms of stocks and shares, creating depth in the market.
Disclosure requirements: In an effort to improve transparency, the SECP directed the listed companies to submit quarterly accounts to the Registrar of Companies, as well as to shareholders and to the stock exchange.
The SECP has to ensure disclosure requirements under the Companies Ordinance 1984. All the relevant International Accounting Standards (IAS)have also been adopted by the SECP.
FINDINGS: The reform measures introduced so far by the SECP are inter-linked. The reforms have restored investor confidence to a great extent and brought integrity to the stock market in Pakistan.However, more attention is required on the part of SECP. KSE-100 index has risen 112 per cent during the year 2002. But this steep rise is not supported by any significant improvement in the fundamentals of the economy or the stock market.
The growth in the GDP was less than 3 per cent in fiscal year 2002 (Economic Survey of Pakistan; 2001 -02). The SBP General Index of share prices decreased to 106.7 in FY 2002 from 128.8 in FY 2000, though KSE-100 index increased to 1,770.1 from 1,520.7 during the same period. The number of companies that declared dividend decreased to 370 in FY 2002 from 470 in FY 2000.
The number of companies listed on KSE is constantly on the decline. It decreased to 725 in FY 2002 from 782 in FY 97. Foreign investment in the capital market has been declining. There was a net outflow of Rs1,127.9 million, Rs1,128.5 million, Rs5,842.4 million, and Rs4,802.4 million in FY 1999 to 2002 The number of listed shares trading at par or above par was 43.8 per cent in 2002 compared to 37.7 per cent in 2001 - an increase of 8 per cent, compared to an increase of 112 per cent in the index of KSE-100. (See the table.)
The market price of some shares multiplied by four times in the year 2002. What determines stock prices? In a nutshell, it is a company’s ability to generate cash-flows now and in the future.
A company’s ability to generate cash flows depends on its
(1) earning power, present and future; (2) its plans for future investments and growth; (3) its quality of assets; and (4) its quality of management. (Brigham and Ehrhardt 2001).
However, the regulators of stock markets in Pakistan do not give credence to these fundamentals.
According to them stock prices are based on 90 per cent sentiment and 10 per cent economic fundamentals (Khalid A Mirza, Chairman, SECP as quoted by Muhammad Ilyas in Dawn dated 24th January 2003). The above-mentioned indicators lead one to believe that increase of 112 per cent in stock prices in 2002 was on account of speculative buying in 10 to 15 stocks. There was no across-the-board increase in the value of shares.
The market was fueled by the inducing expatriate Pakistanis’ funds, on the promise that the return on investment would be 15 to 20 percent. Similarly, retired pensioners, are investing in stock market in the hope of earning 15 to 20 per cent, as promised by the brokers and dealers. Commercial banks (and other financial institutions) have also jumped into the stock market in the hope of getting quick profits: In the past too, they suffered heavy losses on this account and for years their balance sheets carried ‘Provision on account of diminution in the value of investments’. Instead of advancing loans for industrial development, they are indulging in speculative activities.
The reforms measures taken by the SECP may have contributed to the rise in stock prices but July 1998 should not be forgotten when KSE-100 hit the low of 765.74 from the high of 2661 of March 1994. The KSE-100, after touching the figure of 2954.53 in the third week of January 2003, declined sharply and, within five days (20th to 24th January 2003), it lost 345.08 points, closing at 2609..45. The declining trend has not stopped and on 7th Feb 2003, the index was less than 2500. The KSE had to apply circuit breakers to check free-fall of stock prices. It may be added that the KSE has the highest turnover rate in the world stock markets. The regulators and brokers proclaim it with pride, but this does not seem a healthy sign. It points to a highly speculative market.
The massive buying was done on the back of carry over transactions (COT), as result, the rates of COT market had hit record highs in the month (January 2003), which led to sell-off in the market. COT rates rose to well above 50 per cent at the KSE, and 118 percent at LSE! Some insiders allege that a few a major players have already left the market when the index was 2500, after earning handsome gains. To curb excessive speculation, the SECP issued notices in third week of January 2003 to 13 brokers of KSE for “over-stretching their financial capacity” and allied settlement problems in the carryover market.
One of the objectives of capital market reforms was to eliminate tax and investment policy distortions. Funds generated through contractual savings are mostly contributed by lower and middle class of the Pakistani society. They constitute life-time savings of the people nearing retirement. It has been policy of the Government, all along, to invest these savings in a portfolio of relatively less risky securities. Sixty per cent of life fund was invested in government-approved securities.
Forty per cent of the fund is invested in common stock. Investment in common stock has been raised to fifty per cent, exposing this class of citizens to more risk. Such citizens are, by and large, risk-averse. They should not have been put to greater risk.
Income tax on capital gains was waived. This exemption has been continuing for several years to encourage trading in stock market. Instead of removing distortion, this concession itself has created distortion in the capital market and led to speculative buying and selling.
RECOMMENDATIONS: To help understand the true market conditions, the SECP need to direct all the three stock exchanges to construct three price indices. One, measuring the performance of 30 most volatile shares where speculative buying and selling is conducted. Second, price index of the remaining shares. Third, price index of all shares listed on the market. This measure would assist the SECP to monitor the trading in a more meaningful manner, and help the investor to understand the price rise and fall based on total performance of the stock market.
Almost sixty per cent shares listed on the stock market are traded below their par value. However, in recent past, when the SECP allowed the companies repurchase of their shares, often the companies had to pay premium of more than 100 per cent. This shows that share prices are deliberately depressed by the dealers or major shareholders. The SECP need to adopt measures to remove this distortion.
To curb speculation and carry over trading, the Futures market needs to be strengthened. Instead of ‘badla’ financing, the commercial banks need to be encouraged to extend financing facility to traders.
Interest of minority shareholders is still unprotected. The SECP could facilitate the election of one member on the board of directors to protect their interest.
Investment banks, insurance companies, leasing companies, and modarabas are the sectors that are facing a number of problems. Close attention of SECP is required to create level play field for these NBFIs. Also, they need to be regulated and monitored on a systematic basis.
Corporate debt market is almost non-existent. Similarly, there is no over-the-counter market for government securities and other money market instruments. The SECP need to make concerted efforts to develop these markets.
To create flow of real capital, primary markets need to be developed. In addition to common stock and Term Finance Certificates (TFCs), preferred stock, and convertible bonds could be encouraged by SECP to attract new capital, especially from expatriate Pakistanis. Rs299 billion of capitalization created in the year 2002 via the secondary market has merely changed hands without adding productive capacity. Had it been invested in the primary market, it would have added significantly to GDP and created approximately 300,000 jobs! Therefore, The SECP may devote part of its expertise and attention to the creation of enabling environment for development of the primary market.
