The writer is a former governor of the State Bank of Pakistan.
The writer is a former governor of the State Bank of Pakistan.

There is an impression that if the stock market is booming (with price earnings ratio and dividend yields of our market comparing quite favourably with those of other emerging markets) the economy must also be doing well, and vice versa. In other words, the stock exchange index is a good barometer of the state of the economy. The argument proceeds that the nosedive of stock prices in recent days has more to do with sentiments soured by political uncertainty — prompting some, especially foreign, investors to reduce their exposure — and not because economic fundamentals have suffered.

Most economists would argue that stock markets tend to be more vulnerable than other markets to generally held misconceptions. While not saying that the powerful rally in the KSE-100 Index in the last few years was not influenced at all by the improved trajectory of GDP growth, the relationship of stock prices with the state of the economy or its future prospects is at best tenuous in the short to medium term. Other possible explanations of stock prices being high could be a) that these gains reflect the weaknesses of the economy rather than its strengths, (this article attempts to expound on this argument), and b) that it is an outcome of some developments in the shape of shifting market shares (see later below).

By no stretch of the imagination is the KSE index a measure of the economy as a whole, despite such a popularly held view peddled by stock brokers and the government. And the belief that there is a strong relationship between prices of shares and real investment that enhances the productive capacity of the economy is questionable.

To begin with, equity prices reflect profits and not incomes as a whole. They only mirror a part of overall income that is thrown up as profit. Had the share of profits in incomes been steady then it would not have been an issue. But that is not the case. The share of profits in national income varies, having been much higher in recent times, partly because of the high rates of protection accorded to large sub-segments of industry and not as a result of their improved operational efficiencies and increased global competitiveness. The profits of many of these have grown sharply without equivalent growth in GDP and a broader base of enhanced incomes, raising doubts about the strength of the linkages between profits and overall economic prosperity.

By no stretch of the imagination is the KSE index a measure of the economy as a whole.

Next, they reflect, particularly in our case, the lack of other investment opportunities, largely owing to our skewed tax structure that incentivises such investments and speculative behaviour as opposed to other economic and commercial activities. For example, in 2016-17, investors in the stock market pocketed capital gains in excess of Rs540 billion but paid a mere Rs15bn as tax. Furthermore, as most followers of the Pakistan economy know, our stock market is still relatively thin (in terms of the available float of traded shares and the scale of participation) and generally perceived, to some extent unfairly, to be the handmaiden of large brokers who manipulate stock prices.

By buying a stake in a company, one is buying a share of future profits. The worth of such an investment to an investor depends on the available options, the returns on other investments in terms of money set aside today for income that will be received tomorrow. And if share prices are high it suggests that investors are prepared to pay more for a certain level of profits/future incomes in the form of dividends and/or capital gains.

The argument raises the question of why the private sector is not investing more (the investment-to-GDP ratio continues to be rather low) despite the high rates of profit. This would be a pertinent query since most of these companies, being listed on the stock exchange, would not be under-declaring their investments for expanding productive capacity, unless we argue that the present political instability or experiences pertaining to policy unpredictability prevents them from taking long-term positions.

Part of the explanation could be that some are making high profits because of the market power they exercise as monopolies, as active members of insidious cartels, being guaranteed high rates of return (eg IPPs), by arranging government subsidies or a more favourable import tariff regime, with limited incentive to invest in the short to medium term to expand their manufacturing and related capacities and businesses.

It had also been hinted that a large part of the growth in profits of the companies listed on the stock exchange is on account of their increased market share at the expense of small-scale enterprises, without this development resulting in a concomitant growth of the GDP or of overall incomes.

In Pakistan, SMEs face infrastructural constraints in the shape of a reliable and efficient infrastructure of energy (while lacking the wherewithal to generate their own power), water, transport and communications and reasonable access to finance. These constraining factors impact their functional efficiencies and their capability to compete. The problems on account of infrastructural deficiencies are more acute in the case of SMEs since they are located in an unplanned, uncontrolled and dispersed manner.

Until recently, underdeveloped infrastructure like road networks, transportation, etc. had helped create sheltered local markets for small enterprises. The only competition they encountered was with each other because of the overcrowding in such a market. However, with the expansion of the network of roads, large units have extended their operations to rural segments of the market for their products, thereby opening up markets that were earlier sheltered because of product and geographical segmentation of the market.

Finally, globalisation has been wreaking changes requiring forced adaptations in technology, and speedily. Companies are switching from large fixed investments to computer-controlled flexible specialisation. This development is particularly significant in our case because old manufacturing and associated technologies are no longer available. This provides further explanation for the reduced share of investments in brick and mortar and extended production and processing lines (partially reflected in the low investment-to-GDP ratios), as was the case in the past, which also created more job opportunities.

The writer is a former governor of the State Bank of Pakistan.

Published in Dawn, August 22nd, 2017

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