February 22, 2004

‘In spite of the country’s impressive economic growth that would touch six per cent this year, industrial activity has not been as robust,’ concedes Moin Fudda, who heads the KSE

MOIN M. Fudda, who is the third managing director of the Karachi Stock Exchange since the office was created by the Securities and Exchange Commission of Pakistan, under the Asian Development Bank’s Capital Market Reforms Program, believes that the separation of management from the Board of Directors, which mainly comprised stock brokers, has brought greater transparency to stock trading. He claims to have tightened risk management measures, which are evident by the fact that despite a 19-month roller-coaster ride, the KSE, contrary to past practices, did not have to be closed for a single day.

Mr Fudda says he has the capacity to stand pressures. “The number of small investors in stocks is rising and never have so many people made a profit so quickly as wsa the case with the recent Initial Public Offering (IPO) of the Oil and Gas Development Company Limited,” he says.

However, he concedes that Pakistan’s stock market lacks depth, and is strongly critical of the market which is driven not by liquidity, but on the back of borrowed money, which in market term is called Carryover Trade (COT) or badla.

The following are excerpts from the interview:

Q. Let’s first talk about the world markets. The MSCI World Index showed a rise of 29 per cent for 2003, which marked the best year for global equity markets in 17 years. What do you think could be the reason for such a surge of investors in equities?

A. World markets had climbed to dizzying heights in 1998 and 1999 on the back of telecoms, media and dot.com boom. But that bubble burst and the markets had to endure a long bear run. Major corporate scandals had also to do with the deep depression in global markets. But from March 2003, the world markets began recovery to display improved performances, as the US started its campaign in Iraq, corporate scandals died down, regulators tightended measures for true accounting, balance sheets got repaired and investors’ confidence in the equity markets was restored.

Q. World Banks’ 1989 Report suggests that stock market expansion is a necessary natural progression of a country’s financial development. But some economists dispute the notion. What are your views?

A. Well, I would say that the progress and expansion of the stock market is indeed one of the indicators — and a powerful indicator at that — to gauge the financial development of a country. Of course, the rise or fall in stock values have to be seen in conjunction with other factors. But it is difficult to see how stock market can boom in times of depression — or when the political and financial conditions of a country are weak, or vice versa.

Q. In a little over two years since January 2002, equity values in Pakistan’s capital markets have climbed by an incredible 179 per cent. What do you think are the factors that have triggered this stock boom?

A. One can recount a number of reasons. It can not be denied that sea change in economic management has much to do with it. The positive change in geo-political situation; lifting of sanctions; huge inflow of foreign remittances by expatriate Pakistanis; unprecedented surge in foreign exchange reserves; continuity of economic policies and better operational results of blue chip listed companies can be some.

Also, let me recall that on July 14, 1998, the Karachi Stock Exchange had hit rock bottom with the Index at 765 points. And since Pakistani stocks were trading at attractive price-to-earnings ratios, the market had nowhere to go, but up.

Q. But critics argue that Pakistan’s stock market is not necessarily the barometer of the country’s economy’ for the rise in share prices merely reflect increase in paper value of corporate Pakistan. It does not correspond to any underlying development in the country’s economic and industrial activity.

A. If you take all that as merely paper value, then it would have to be admitted that the asset values in Pakistan were grossly undervalued. That is also represented by the low market price-to-book value of company shares. It follows then that with the improvement in the country’s political and economic conditions, the assets values started adjusting to their real worth.

Having said that, I must also admit that in spite of the country’s impressive economic growth that would touch six per cent this year, industrial activity has not been as robust. But ask an industrialist and he would grumble about many things. Industrialists have been used to double-digit return on investments; now they find the margin to have dropped to 7-8 per cent, to which they are reluctant to reconcile.

Then, there is the issue of high utility charges and as many as 19 different taxes on industries. There is also the gruelling competition that industries face from the influx of Chinese products, and finally the implementation of the WTO regime from 2005 that hangs like the sword of democles. So industrialits are reluctant to go through all the hassle for a lower return compared with other avenues available to them, including stock market and real estate.

Q. But doesn’t this criticism look justified when we see that in the last six years, no more than two dozen companies, some of them being mutual funds, have turned to the bourses to raise funds in fresh equity offerings. Is it fair then to expound the theory that stock markets are vehicles for mobilization of funds that are then channelized into industries?

A. Industries have raised 4 to 5 billion rupees in new equity offerings, but surely the flow of Initial Public Offerings (IPOs) in the secondary market has been slower than in the early 1990s. One reason for that was that the existing stocks of companies in almost all sectors, like banks, leasing, modarabas, textiles and others, were trading at hugely discounted values. It would have therefore made little sense for company sponsors to float shares in those sectors and risk the possibility of undersubscription. Now that the stock values have risen due to a two-year boom, I foresee a bee-line of new equity listings.

In response to the second part of your question, I may say that one must make his own conclusion on the proportionate development of Pakistan’s economy in relation to the stock market boom. But there has been substantial investment in the textile, energy and communication sectors. Now if there has not been a boom in new equity listings, you have also to consider that there has been a record number of companies that have come forward to raise money through debt instruments, called Term Finannce Certificates (TFCs).

Also, you have to ask yourself why certain banks — remember not all banks, but the ones that invested heavily in equities — are able to lend money at low interest rates? Because they made considerable profit through dividends and capital gains from investment in stocks.

Q. Did Pakistan’s stock market benefit by the tremendous inflow of funds from expatriate Pakistanis after 9/11, or do you agree with the detractors who think that just about 10 per cent of money found its way into the stock market and the remaining went into consumption and real estate?

A. It is difficult really to quantify how much money has entered the country as a reversal of flight of capital post 9/11. But it is true that funds appear to have found their way into the real estate and debt instruments. As far as investment in stock exchange is concerned, new money has come from three major sources: banks and financial insitutions; high net worth individuals; and expatriate Pakistanis. Since our stock market was of a small size — just around $6 billion — until the current boom began, even a small inflow of expatriate dollars following 9/11 made a major difference in relative terms.

Q. Is the liberalization policy that has removed all barriers to the repatriation of profit and funds a laudable move or should foreign investors be compelled to invest all or part of the profit they earn on industrialization within the country?

A. No investor would like his capital to be tied up. When the local industralist is shy to put money in new ventures, how can you expect foreigners to do that. Besides, it is important to realize that what investors hate most is inconsistency in economic policies. I think it goes to the credit of this government that it has continued to pursue a consistent policy with no major deviations. This has led to improved confidence among foreign investors.

Q. Our stock markets are widely believed to lack depth and as much as 90 per cent of the total trade volume on any particular day is generated by no more than 15-20 companies, while the remaining 670 listed companies are almost dormant. Why?

A. Well, that’s true to a great extent. About 80 per cent of the volume is generated in 30 scrips, and there are reasons for that. These companies have larger free float compared to others where the shareholding is tightly held, mostly by the sponsors. The textile sector is one such example where companies have generally been ‘unkind’ to their shareholders. The textile sector lists the largest number of companies on the stock exchange and yet most of them do not pay dividends to their shareholders.

As regards trading in scrips, let me add that things are changing for the better. Two years ago, there were just 50 active listed companies. Now trading takes place in 250 companies, many of which we call second-tier scrips.

Also, the current regulations permit COT (trading on borrowed money) and futures trading in these scrips, which is why there is considerable speculation in those top-tier companies. A criticism which I think is quite justifiable is that our stock markets are driven mainly not by liquidity, but on the back of COT, or badla as it is called. This needs to be changed, and the State Bank has already drafted rules to switch over from COT to margin financing by banks.

Q. It was noticed that in recent large public offerings of equities, such as that of the OGDC, where small investors were certain to make huge immediate gains, no more than 98,000 applications were received for subscription. Doesn’t that indicate that the number of small investors is pathetic in relation to the country’s population of 140 million? What are your suggestions for expanding the investor base?

A. There is no denying the fact that the investor base in Pakistan is very small. Of course there are reasons for that as well: low literacy rate, lack of desired infrastructure, underdeveloped level of automation, negative perception about the capital market, and so on. But, as you said, 98,000 individuals applied for shares in OGDC. This number has shot up to around 150,000 in case of the latest offer of Sui Southern shares by the Privatization Commission. So the number of small investors is rising. But, surely, the management along with other stakeholders, such as stock brokers, is trying to increase the retail investor base.

Q. In relation to stock markets in general and Pakistan in particular, it is widely believed to be driven more by investors’ perceptions, rumours and tips, and less by research. Do you think that research material on companies is available to an ordinary investor in simple terms and language that he can understand?

A. Well, interestingly, many stock strategists in the developed markets also advice investors to ‘buy on rumours and sell on news’. In our case, possibly much of both is done on rumours. And it has also to be admitted that most research reports published by major stock brokerage firms in Pakistan are in the English language. Probably that is meant to attract foreign fund managers and high net worth individuals. There is the need to publish research material on companies in easy-to-understand local language.

A recent development in this regard is that banks have been allowed to establish stock brokerage firms as subsidiaries, which is an encouraging development. Due to the advantage of their branch network, including in the rural areas, banks would possibly be able to do the job of attracting investors through equity research reports in plain, local languages.

Investors have of course to make their own decisions, but for small investors, generally, it is thought better to go through the route of mutual funds, which have wide dispersal of funds and are generally managed by competent invesment managers. In India, for example, the Unit Trust of India (UTI) — which is a mutual fund — represents the highest number of stakeholders.

Q. To an ordinary man, Pakistan’s stock markets have carried the image of a ‘rich man’s club’, where stock brokers make big money, while small investors lose the last rupee. What would you say on this?

A. A host of reforms have been undertaken in implementing broad-based market reforms in the field of risk management, corporate governance, transparency and investor protection, which have brought more institutions to the stock market. No doubt, some people make more money than the others, but at least in the last two years, the stock exchange has enriched almost every investor in equities.

A good example is the privatization of five per cent shares in the OGDC by the Privatization Commission: 98,000 small investors had applied for the shares, and each one of them has already made gain of Rs20,000 on an investment of Rs32,000. Where do you get that kind of return on your investment? But small investors are trapped only when they fail to distinguish between need and greed.

Q. What more needs to be done?

A. We have taken great strides in the last two years. To underline just a few, capital adequacy and exposures are being monitored on an hourly basis; undisclosed trading has been implemented; internet trade is being promoted; quarterly financial reports are now compulsory and the stock exchange passes on the information and other material disclosures, such as announcement of financial results, to investors within three to five minutes of their receipt from companies.

A lot of course needs to be done further. Among other things, we are now trying to introduce crossborder listing with other countries and, let me say, some progress has been made in that direction with companies in the Middle East.

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