SINCE the early 1980s, in the name of de-regulation and expansion of markets, what the regulators ended up accomplishing unintentionally was strengthening and extending the reach of speculators and glib-talking market players. This scenario largely has to do with mediocrity that has slowly been creeping into the front lines of regulators, and the institutions they regulate.
To regulate the markets they have helped expand, regulators have engaged in capacity building but with manpower that is often wanting not only in requisite knowledge and skills but, more importantly, the vision to anticipate market stress and the technology to manage it. This is a continuing saga encompassing several periods of worldwide market stress since early 1980s. Regulatory deficiencies permitted speculative balloons to inflate and offered little in terms of strategies to revive shattered economies once these balloons burst.
Market movements now have less to do with genuine rise or fall in demand or supply. Despite regulatory checks, fate of the markets remains in the hands of speculators who exercise unassailable influence over them. They can destabilize markets, virtually at will, and regulators and the institutions they regulate, just pick up the pieces to re-build the shattered markets while speculators make hey.
Remember the ‘Black Monday’ in October 1987 that saw stock prices tumble by as much as 43 per cent in the first 90 minutes of trading at London Stock Exchange, or George Soros and his billion dollar profit in a day from foreign exchange trading, or the turmoil in South East Asian foreign exchange markets in 1997 that seemed uncontrollable for a long while, and the near crash of stock markets everywhere that followed in its wake?
To save the British pound from the onslaught triggered by George Soros’s speculative selling of the pound, Bank of England changed its discount rate three times in a day pushing it to as high as 54 per cent p.a. but in the end gave up because speculative selling of the pound was far too rapid for the Bank of England to reverse employing the limited regulatory options at its command.
Financial derivatives – masterpiece of the collective genius of commercial and investment bank treasurers (some now being traded in Pakistan) are risk hedging instruments. Ironically, these are the very instruments investment in which led to major disasters in banking. Barring Brothers crashed in 1995 and Union Bank of Switzerland suffered its single biggest loss because of reckless investment by its Singapore office in funds hedged by derivatives. There were many other less damaging instances of the same nature.
Oblivious to the consequences of their flawed trading practices, the mediocre market players of today spend their energies less on polishing their skills but more on learning the art of glib-talking to convince regulators to re-engineer regulation suiting their purposes. Regulators don’t realize that re-engineering of regulation that is tilted heavily in favour of simplification makes regulation risk-prone, and allows systemic risk to creep up unnoticed as demonstrated by the latest melt-down of the Karachi Stock Exchange.
Giving in to lobbying by expediency-oriented stockbrokers, last year SECP allowed 30-day forward trading in shares. This was a significant relaxation because any laxities in enforcing regulatory limits on forward trading were bound to have disastrous consequences. Prudence required that forward trading in shares should have been accompanied by crucial regulatory controls that are imposed by stock exchanges, the world over, to keep speculative trading within manageable limits.
Firstly, margin requirements (similar to those imposed by SBP for lending against shares) should have been imposed on investors for entering into forward sales contracts with stockbrokers. These margins should have been imposed in slabs stipulating higher margins as a broker’s exposure an individual investor went up. It would have made speculation progressively more expensive for rash investors.
Secondly, since sale/purchase contracts are entered into with exchanges, the stock exchanges should have been instructed to make margin calls on stockbrokers against their outstanding forward contracts if prices of shares the brokers had bought forward (for onward sale to investors) went up from their contracted price. Margin calls are a standard practice of good stock exchanges to discourage excessive speculative activity.
On September 1, 2004 SECP issued a draft instruction circular on margin trading inviting response thereon by stockbrokers. But it neither stipulated stock exchanges to make margin calls on stockbrokers, nor asked stockbrokers to impose margins requirements on individual investors. Firstly, the proposed regulations were defective because they didn’t impose controls to check speculation by investors and, secondly, however defective the regulations, these were not imposed simultaneously with the permission for forward trading.
In this free-for-all scenario by depositing miniscule margins with their stockbrokers, investors were able to buy shares forward worth many times the margins provided to stockbrokers. Secondly, stockbrokers could go on entering into forward sale contracts without being restricted in this reckless activity by margin calls from stock exchanges. These serious regulatory gaps were fuelling demand and sending KSE-100 index up at a bewildering pace.
During the past six months market capitalization of KSE went up from Rs. 1.346 trillion on September 15, 2004, to Rs2.813 trillion on March 15, 2005 i.e. by 109%, although during this period the capital injected into the market through equity issues by Attock Petroleum, KAPCO and few smaller issues added up to little over Rs15.8 billion. It was indication of speculative activity at a frightening scale. It’s a pity that the regulators didn’t notice the truth behind the rise of KSE-100.
Until two weeks back, top-ranking government officials and KSE administrators were emphatically stating that skyrocketing of KSE-100 index actually reflected ‘economic growth’. I wonder what explanation these wise men now have for the sudden evaporation of nearly 20 per cent of ‘economic growth’. KSE-100 index has tumbled from its peak by 19.28 per cent in the last seven days. It could have fallen further had lower price locks nt been applied to further selling in certain shares. The scenario should have reminded the regulators of the stock market-balloon that had inflated in 1993 only to burst within weeks, with a big bang.
Now that the stock market melt-down is unstoppable (even with the 7-day extension on maturing forward contracts), speculative investors will default on paying for their forward purchases (or simply disappear) leaving brokers to take the rap. Rumour is that many (two for sure) may default on their contracts. It could trigger a domino effect with disastrous consequences for the reputation of KSE – the exchange rated the best in Asia, only months ago. It could also jeopardize the prospects of attracting direct foreign investment for privatizing state-owned enterprises.
Another example of over-simplifying regulation (instead of re-engineering) was provided by SBP last week, which lifted virtually all controls on housing loans except for the restriction that the combined effect of the borrower’s monthly repayment of loan liabilities should not exceed 50 per cent of his/her take-home income. To assume that a fixed income earner can afford to part with 50 per cent of his or her income for repaying loans, is overly optimistic, especially in an environment of rising prices and interest rates.
The move will only push up the demand for the limited stock of properties and reward property speculators even more. House buyers will end up owning properties at highly inflated prices financed by bank loans based on inflated prices. If troubles, like the one going on in Waziristan or the one brewing in Balochistan, escalate resulting in large-scale flight of capital, house prices could fall rapidly leaving house buyers with huge negative equities (grossly deflated asset value compared to the loan liability).
The stock and property market scenarios described above have surfaced again and again in almost every de-regulated economy. But, it seems that market players don’t believe in the proverb ‘history repeats itself’. And why should one blame them; history, even about major market failures (leaving out those caused by warriors, kings and politicians) doesn’t form part of the curricula of business schools in Pakistan. Learning lessons from history has simply gone out of fashion – a trend that would eventually prove a great blunder.
Business schools must re-examine their curricula to incorporate therein market debacles of recent times so that students don’t place excessive reliance on fancy financial mathematics.
They must know that ultimate determinant of market profile is human behaviour that repeats itself in similar historical settings. Students must learn about limits to relying on financial mathematics if they are to become responsible future managers of the economy. Mediocrity must be stopped from creeping into the front line of our institutions.
