February 22, 2004

If you are involved in the stock market, watch your steps, as claims of its success are wonderfully fictitious. Increasing liberalization has removed almost all barriers to foreign investors with little loyalty to the locals who may soon find the egg on their face

THE recent stock market boom in Pakistan, which saw the index go up by 112 per cent in 2002, and another 70 per cent at one point in 2003, is widely presented to reflect the growing strength of Pakistan’s economy. the Economist, in its November 2003 issue, attributed this to the liberalizing reforms carried out by the government. The government could not agree more. The fact, however, is that the view of both the government and the Economist could not be further from the truth.

Stock markets are supposed to facilitate the working of a market by bringing opportunities and investors together. In this way, they contribute to the development of an economy. A rise in the stock market normally indicates heightened confidence of investors and the availability of several new investment opportunities.

The Pakistani stock market does not fit this profile. First of all, from amongst its 699 listed companies, only 15-20 companies account for 90 per cent of the total trade volume, indicating that the vast majority of the market is, in fact, dormant. Secondly, and more importantly, this record growth in the market is quite divorced from the process of Pakistan’s economic and industrial development. It is clear that the immense growth in the stock market has not led to a corresponding rise in industrial activity in Pakistan.

This is because the stock market’s rise (as well as the increase in Pakistan’s foreign exchange reserves) is primarily due to the remittances of expatriates who are increasingly nervous about their future in the wake of what is known as 9/11. This capital, part of which has ended up in the stock market, has not resulted in new projects or expansion of existing companies. Rather its impact has largely been price inflation.

The true state of Pakistan’s economy is reflected in the fact that despite having large sums of money now available, the industrialists are still reluctant to set up any major projects. Even banks, which borrowers typically prefer over the stock market for raising capital, are having problems lending out the large amounts that are sitting idle with them.

One investment banker who works with a large multinational bank, remarked, “We are even willing to make the whole business plan, the feasibility, build the whole thing for investors ... but nobody is interested in borrowing to set up any industry here.”

The only industry where some significant amount of investment has taken place is textiles, where $3 billion has been spent to prepare for the expiry of the Multi Fibre Arrangement in 2005. Ironically, the textile industry did not raise finances for this $3 billion investment through the stock market. Most of this investment was completed through sponsor/company sources and some credit off-take. Thus, all this activity in the Pakistani stock market is not reflective of the key industrial sector i.e. textile, in the country. The fact is that the textile industry, which is currently the backbone of Pakistani economy, hardly uses the Pakistani stock market.

It appears that our focus and disproportionate emphasis on the stock market is more driven by our wholehearted acceptance of the free market ideology than empirical evidence. More often than not, developed countries, such as the United Kingdom and Germany, have not relied on stock markets in key stages of their development. Japan’s development was primarily financed through the group bank system, which was much better suited to cope with the particular asymmetries of information and transaction costs than the Anglo-Saxon stock market system.

Similarly, even in the most sophisticated capitalist economies like that of the US, the role of stock markets has been relatively limited. This is true even now. Thus, in the US and the UK, during the period 1970-1989, internal company sources accounted for 91 per cent and 97 per cent of finances raised, leaving a marginal role for equity generated through the stock markets.

Recognizing this, Joseph Stiglitz, ex-chief economist of the World Bank and a Noble Prize winner, stated, “... (T)he extensive media coverage of the stock and bond markets makes it tempting to conclude that these markets are the central institutions of capitalism. But in fact, ... a relatively small fraction of total investment is financed by new equity and bond issues.”

Chinese, Indian and Russian cases present more evidence against the role of stock markets as key vehicles for the growth of developing countries. Stock markets emphasize the role of financial capital, often downplaying the role of human capital. These countries have primarily grown through reliance on human capital rather than financial. China only shifted its focus to financial capital once it felt it was relatively ready to compete for financial capital on its own terms.

For developing countries, the primary argument given in favour of establishing stock markets and then liberalizing them as fully as possible is that they will help bring in the much needed capital from national and international sources to finance industrialization and development projects. Empirical evidence flies in the face of this theory.

At the national level, stock markets do not always increase savings, and evidence shows that most often the savers just switch their savings from banks to stocks in search of higher rates of return. At the international level, experience has shown the capital that has flown into developing countries through stock markets over the last two decades is primarily portfolio money that has not shown any long-term commitment to firms or projects in developing countries. This kind of capital inflow was a principal contributor to the South East Asian financial crisis, after they had liberalized their stock markets.

Moreover, liberalization of stock markets in order to allow international capital access to local markets leads to close links between two inherently unstable markets, the stock market and the foreign exchange/currency market. There is also some evidence of adverse selection of investors in such situations too, i.e. the more undesirable, speculative investors are more likely to be attracted to invest in developing countries under these circumstances.

Dr Ajit Singh, a professor of economics at Cambridge University and one of the most prolific researchers on the subject, goes even further in his criticism of stock markets. According to him, stock markets do not even deliver on their promises of increase in efficiency through take-overs and pricing transparency.

Stock markets do not necessarily increase efficiency because they generally allow bigger, potentially more in-efficient companies to acquire smaller, efficient companies. Similarly, pricing is deeply affected by the perceptions of investors and differences in the availability and use of information.

In fact, investor perceptions are critical, and developing countries cannot afford allocation of resources through perceptions of trigger-happy analysts. During the East Asian crisis, portfolio managers sitting in New York and London linked Thailand and Korea together, so that when the Thai baht collapsed they started pulling out of Korea too, even though there is very little trade between the two countries, and no rational reason why collapse in one economy should affect the other.

Alan Greenspan, the head of the US Federal Reserves, said in 1998, “The US experienced such a sudden change with the decline in stock prices of more than 20 per cent on October 19, 1987. There is no credible scenario that can readily explain so abrupt a change in the fundamentals of long-term valuations on that one day.”

Ultimately, the one explanation that is used for such events, including the East Asian crisis in late 1990s, the Latin American crisis in the 1980s, and the dot-com bubble, is ‘investor perception’, which economists have conveniently assumed away in their calculations of the usefulness of stock markets for developing countries.

Ajit Singh emphasizes that the volatility that is engendered in the economy by liberalized stock markets undermines the financial system as a whole, by making share prices less useful as guides to resource allocation. This often stops risk averse investors from investing in the stock market, thereby making capital more expensive and discouraging conservative firms from listing on the stock market.

Evidence of all of these can be found in the Pakistani case. For instance, in the last two years at least 25 firms, including Phillips Pakistan, have de-listed from the stock market, and more are expected to do so in the near future. This de-listing has also been hastened by the stringent corporate governance standards that are being enforced.

Dr Ajit Singh, like Joseph Stiglitz, is a proponent of capitalist industrialization. Yet both find it increasingly hard to justify many of the policies that the World Bank and the IMF have imposed on country after country.

Dr Singh suggests, “stock markets are potent symbols of capitalism, but paradoxically capitalism often flourishes better without their hegemony. Contrary to the World Bank report (1989), stock market expansion is not a necessary natural progression of a country’s financial development. Historically such progression has not occurred in leading continental European economies. In the more recent post-World War II period, countries like Germany and Italy have been able to achieve their economic miracles with little assistance from the stock market.”

The emphasis on ‘functioning’ stock markets in developing countries such as Pakistan is created by international financial institutions (IFI), which are, in turn, motivated by large funds desperate for more speculative opportunities. The push towards greater stock market liberalization in developing countries under the guidance of the IFIs needs to be contextualized, as it has coincided with the saturation of western markets, realization of greater growth opportunities in the developing countries and demographic changes in western countries where an ageing population has large amounts of savings that the portfolio managers promised to invest for high returns.

The mythical ‘success’ of the stock market serves as a wonderful, albeit entirely fictitious, record of the current government’s financial policies, whose finance minister is hell-bent on imposing the IFI’s agenda on Pakistan.

The actual performance of the Pakistani stock market is woeful, and its contribution to Pakistan’s development more subversive than constructive. Its increasing liberalization has removed almost all barriers to foreign investors with little loyalty to Pakistan’s development needs.

At the same time, local companies are provided with little incentive to invest and expand. Despite its record growth, then, the stock market has failed to attract new issues from local companies in any significant manner. Finally, and significantly, more than 90 per cent of the money that expatriate Pakistanis sent to Pakistan after 9/11, has reportedly gone into consumption and real estate, instead of Pakistan’s booming stock market or investment into industrial projects. This has created a property bubble that may burst any time.

Industrial development within Pakistan may stand a better chance through financing by banks. A well regulated, less liberalized stock market may be nice to have on the shopping list in later years, but at this stage it is no more than a ritual, enacted to satisfy the IFIs and provide foreign investors with a licence to ravage a developing economy. Ultimately, the capital that stock markets promise to bring into the economy is only useful if the overall policy regime supports local investment and development. And this is exactly what is not happening in Pakistan.

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