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S for Stocks, S for Satta

August 14, 2013

Investments can be risky, but risk can’t be an investment. This fine distinction is, however, lost at the Karachi Stock Exchange (KSE) that continues to flirt with risk and demonstrates unearned enthusiasm.

In the past 24 months alone, the KSE has risen by 110 per cent. This irrational exuberance in the stock market coincides with a dismal economic performance in Pakistan, where all sectors of the economy have struggled because of power, political, and institutional crises, to name a few. At the same time, other stock indexes, which are based on more stable and much larger economies, have posted relatively moderate results. During the same time period, FTSE was up by 22 per cent and NASDAQ by 43 per cent. A regional bourse SENSEX, widely known as the barometer of Indian capital markets, was up by merely 14 percent.

Stock markets provide an avenue to invest savings with the intent to see them grow. Risk is inherently coupled with investments, but investments are certainly not a gamble. The market fundamentals, to a large extent, inform the stock market outcomes. In capital markets, liquidity is king. The KSE, according to the London-based The Economist, “is illiquid: only 60 of its 569 listed companies’ trade regularly.” With billions invested in the bourse, such cavalier attitude of investors and tampered oversight by the regulators does not bode well for Pakistan’s capital markets.

The Economist in a recent issue warned investors of the unknown risks inherent in investing with the KSE. “You have been warned”, concluded the magazine. Yet, news outlets in Pakistan, with some exceptions – such as Khaliq Kiani in Economic Times in April 2010 – have failed to raise concerns about the Exchange whose performance is out of step with the socio-economic realities in the country. Whereas institutional investors may have the means and the information to time their exit, the small time investors will be left to cope with the collapsing index, which has been the case in the past.

It was only in 2008, and earlier in 2005, that the KSE lost billions in a matter of days depriving unsuspecting investors of their lives’ savings. Each precipitous decline in the exchange was preceded by unprecedented growth that was not supported by the market fundamentals, but instead fuelled by pure ignorance or hubris. In July 2008, the KSE reported losses for 15 consecutive trading days, the Index’s worst performance in 18 years. The New York Times reported that Index had fallen by 36 per cent in mid-July after reporting record highs only in April. The newly elected PPP government, which seemed inept to curb the market crisis, eventually halted trading on August 28, 2008.

The Exchange crashed earlier in March 2005 when the KSE dropped by 27 per cent after it appeared that investors in case of a collapse may not be able to honour the bets made on margin. Just before the collapse, the Exchange had appreciated by a record 65 per cent between January and March 2005.

The current boom in Pakistan’s stock markets is partially the result of the government’s attempt to legitimise black money. An ordinance promulgated in March 2013 allowed investors to buy stocks up until March 2014 without having to declare the source of the invested funds. Billions of untaxed funds thus made their way to the stock markets where the investors were not charged any income tax. Instead, a transaction tax of 0.01 per cent was introduced instead.

The collapse in March 2005 and July 2008 were preceded by exceptional record breaking highs in the Index. It was the margin calls in 2005 and the politico-economic crisis in July 2008 that sent the Exchange tumbling down, wiping out billions in previous gains. The KSE’s performance in August 2013 appears eerily similar to the pre-collapse trading of the last two crashes. The Exchange has risen by 40 per cent since the start of the current year. Last year, it surged by 49 per cent. At the same time, the economy has grown at a dismal rate of 3 per cent per year in a country where demographic growth and inflation make the 3 per cent annual economic growth rate inconsequential.

The stock markets in Pakistan can mature in size to become a viable vehicle for investments. However, this will require honest and effective regulators to mind the markets. The current regulatory frameworks are inadequate to pre-empt disastrous stock market outcomes in the future.