December 8, 2003	Monday	Shawwal 13, 1424

After dipping by almost 900 points in a matter of 40 days from its peak on September 12, KSE-100 index once again seems poised to shoot through the roof. The irony is that signs of improving India-Pakistan relations is being cited as the reason there for although easing of trade restrictions and a flood of cheap Indian products could threaten the survival of many listed companies in Pakistan, especially in the consumer products sector.

In the past, the Federal Finance Minister, the Managing Director KSE and the Chairman SECP have claimed that a rising KSE-100 reflects economic growth, expansion of our industrial base and streamlining of share-trading practices. Unsuspecting foreigners, who associate the rise of stock exchange indices with genuine economic growth, may be duped into believing this but not the Pakistanis, who confront the bitter realities of life everyday. They know that the rise of KSE-100 index primarily represents speculation, not much in terms of economic growth.

Claims about KSE-100 index representing economic growth could have sounded credible had these claims been accompanied by flotation of a large number of new companies or substantial expansion in the capital base of the existing listed companies. Neither the extent of fresh company flotation, nor issue of supplementary capital by listed companies justifies the meteoric rise of the KSE-100 index. By September 12, this year the rise of 328 per cent in KSE-100 index over its October 2, 2001 low (1075 points) is not backed by growth in any economic indicator.

During the 34-month period ending October 2003, listed capital (debt and equity) went up only by Rs. 23.52 billion and the number of listed scrips by 36. Market capitalization at a staggering Rs. 1.012 trillion reflected a 268 per cent rise over its October 2, 2001 level of Rs. 277.269 billion and amounted to 3,152 per cent of the fresh injection of capital (only Rs. 23.53 billion) since January 01 2001. That’s not all: compared to the 2001 levels, average daily share turnover rose by 253 per cent, and its Rupee value by 436 per cent.

That our stock exchanges are no more the barometers of real growth is a bad omen. That state functionaries now hide behind this farce to cover up their failure at economic management is shocking. Table-1 places in doubt their claims about growth. It indicates a slowdown in investment, particularly foreign direct investment, which declined by 21 per cent over last year because Pakistan continues to be named immediately after Afghanistan among “terrorist” states, has a weak currency that prevents revamping of its archaic industrial base, and has failed to balance the objectives of growth and running fiscal deficits. Together these trends impacted growth keeping it below the levels recorded in comparable Third World economies.

Besides the economy-related issues, there are political stability-related issues that prove the artificiality of the rise of KSE-100. In spite of “restoration” of democracy, the political set-up is perceived to be unstable given its sole legislative focus on fighting over LFO. Pakistan faces external and (according to the President) potent internal threats i.e. potential terrorist acts. Uncertainty abounds and continues to depress investment, a fact accepted even by the federal finance minister in an earlier press conference, given the fact only seven new companies were listed in the past 21 months adding just Rs. 8.77 billion to the listed capital base. In summary, Pakistan is not perceived to be a low-risk country by domestic or foreign investors.

Table-2 shows the performance of the large-end of the industrial, commercial and service sectors. Given the scenario of weak fundamentals, the rise of KSE-100 until mid-October represented a balloon stretched beyond its capacity that could deflate as rapidly. It was imminent because shares of 21 sectors were over-priced by five times or more of the returns on equity earned in 2002, and market capitalization of 10 out of 27 sectors was twice to 20 times of their listed capital although 188 of the 710 listed companies recorded losses in 2002. These trends were baffling since Pakistan’s industry suffers from high costs, low productivity and low profitability.

Yet, as in 1993 banks spurred the rise in share prices, this time they did so directly rather than by pumping money into the stock markets through punters. As per the 2002-03 SBP Annual Report, by June 2003 banks’ investment in debt and equity paper had risen by a whooping 43.5 per cent over its 2001 level. On September 6, 2003 the figure was over Rs. 44 billion. It could well be an understatement since the figure was the sum of the banking sector’s returns of that date. The reason: on reporting dates banks always confine exposures to regulatory parameters but during the period ending on the reporting date they far exceed these limits.

The existing Prudential Regulations restrict banks’ investment in market securities to 30 per cent of their equities (excluding reserves for losses and those created out of asset revaluation). According to the 2002-03 SBP Annual Report, on June 30, 2003 total equity of scheduled banks stood at Rs. 122 billion. Assuming very optimistically that of this amount only 10 per cent represented loss and revaluation reserves, the maximum investment banks could make in market securities should not have exceeded Rs. 33 billion. Should this estimate be correct, some banks may already be in breach of regulations. Reportedly, a large privatized bank and another with Islamic banking profile are the big players in this make-believe game.

The unfortunate underlying reality of our stock markets has been that investors with large stakes are usually not the ones who believe in share ownership. What makes it worse is the fact that those regulating the stock exchanges don’t look at this trend as a worrying sign. A former head of KSE, reportedly, said, “there was no price bubble...share prices keep rising and falling...that’s routine...the market went down on genuine selling.” Shocking, isn’t it?

To compound the tragedy, banks have now joined the ranks of speculators, and did precisely what was feared: between September 12 and November 6 (a period of 40 market days) KSE-100 index fell by 872 points or 18.9 per cent from its peak of 4,604 points. The price bubble (invisible to the regulators) began cracking as banks commenced unwinding their positions to confine themselves to the “20 per cent of unimpaired equity” Prudential Regulatory limit that was to take effect from January 1, 2004. The 18.9 per cent fall in KSE-100 index was largely the result of banks cutting their exposure by just Rs.1.8 billion or 4 per cent of its peak of Rs. 44 billion. The fall, warned the head of a large local bank, could have been steeper had banks not been “supportive” of the stock market.

The sitting KSE Chairman knows how overly dependent is the KSE-100 index on banking sector investment in stock markets and it is hard to believe that the Governor SBP feels otherwise. Thus, when the KSE Chairman met the SBP Governor to seek postponement of the imposition of the “20 per cent of unimpaired equity” Prudential Regulatory limit, the SBP Governor promptly agreed. After that meeting, however, the press has been reporting conflicting views of the KSE and the SBP on whether the dreaded regulation is to take effect from October 2004 or 2005. What is important though is that, at a minimum, banks can continue this charade for another 12 months.

Banks had already figured out that this relief was inevitable. They used the confusion about continuation of their stakes in the stock markets to their advantage by offloading a fraction of their holdings to pull stock prices down. Stockbrokers allege that banks simultaneously reduced the volume of margin financing. Later, the banks bought more shares as the market declined. This may also explain the steady rise of the index after the crucial KSE-SBP meeting. If these assumptions turn out to be the reality, credit goes to the banks that benefited most from the vulnerability they have created for Pakistan’s stock markets placing the regulators on the defensive.

This event brings to the fore a new reality; emboldened by regulatory weaknesses and having failed in managing the sudden flood of liquidity, banks are now a force to be reckoned with in the stock market jugglery that has put the traditional punters on the defensive. This continuing saga will not permit rise of a healthy share owning and trading culture so necessary for encouraging well-managed companies.

Such negative developments would cause irreparable damage to stock markets anywhere, more so in weaker economies like Pakistan’s because their being hostage to speculators erodes genuine investors’ confidence. Pakistan suffered this fate in the early 1990s when stock indices shot through the roof only to remain depressed until 1997, leaving small shareholders impoverished. That bitter experience hasn’t faded from their memories.

It is worrying to note that regulators don’t seem to differentiate between the speculators’ charade that is going on at the stock exchanges, and growth represented by fresh real investment. Market watchers (including the otherwise careful Euromoney) may have been taken for a ride once, but not again. Given the new lease of life, banks may push the index beyond the magical 5,000 points in a matter of weeks but, henceforth, observers will reward growth in real investment, good corporate governance and risk-weighted competitive returns. More importantly, poverty alleviation (today’s popular bureaucratic slogan) will be impossible without rapid growth in real investment and employment creation. It is time the regulators woke up to these hard realities. Time is not on their side.