KARACHI, Dec 1: Financial markets in Pakistan witnessed periods of volatility in the last fiscal year, reflecting the changing fortunes of the country's external account and shifting expectations on interest rates , according to a report released here by the State Bank, on Wednesday.

The report titled Financial Markets Review for fiscal year July-June 2003-04 highlights the developments in various sub-sectors of the financial market during the last fiscal year and provides an insight into the impact of these developments on Pakistan's economy.

Pakistan's financial markets witnessed significant changes in FY04. Interest rates saw a historic low, the rupee reached a three-and-a-half-year high and the capital market too witnessed a new all time peak; all markets also saw improvements in depth and liquidity.

"These developments probably facilitated the economic recovery by catering the rising demand for financial services by the fast recovering economy," says the SBP report.

In the money market, the average repo rates in FY04 were almost one half of those prevailing in the preceding year and the trading volumes were much higher. Capital markets were buoyant as corporate earnings averaged 26.5 per cent. Sixteen public offerings were floated in FY04 amounting to about $1 billion (Rs55.6 billion to be specific).

Most of the new offerings were oversubscribed. The investor base also expanded due to the government's policy of attracting small retail investors to the sale of shares by public sector companies.

"The share of market capitalization in GDP also increased from 19.7 per cent in FY03 to 26 per cent in FY04," says the SBP report terming it as an impressive outcome. "The turnover was also much higher."

The report says that the mutual fund industry also saw a significant growth in FY04 amidst "increasing investor interest from both individuals and institutions." As a result, not only the number of funds increased substantially but the NAV or net asset value of the industry also nearly doubled during FY04. But the report notes that despite a robust growth, Pakistan's mutual fund industry is clearly still under-developed, with only a total of 31 funds and total NAV of Rs97.3 billion or $1.66 billion, which is 1.7 per cent of GDP.

In contrast, the mutual fund industry in India comprises 33 mutual funds offering more than 400 schemes and with the net assets of $33 billion or 5.9 per cent of GDP.

The SBP report says financial markets also witnessed periods of volatility reflecting the changing fortunes of Pakistan's external account and shifting expectations on interest rates.

The changes in market expectations were particularly evident, directly or indirectly, during Q4-FY04 when upward movement in interest rates accelerated amidst rising inflation, the exchange rate suffered a net annual depreciation (for the first time in two-and-a-half years) and the momentum of the two-year-old capital market rally finally faltered."

The inter-bank foreign exchange market witnessed a high-level of activity in FY04. Both forex inflows and outflows were higher than in the previous year. But the net flows were lower as imports of capital goods and raw material rose by 28.8 per cent. In the last quarter, higher import of oil due to large price hike also exacerbated pressures on the forex market.

"In fact, the volatility in the money and foreign currency market posed significant challenge to the SBP policy, as it sought to strike a balance between interest rate and exchange rate stability, containing inflation, and sustaining the growth momentum."

"On the positive side, the increased market volatility also led to an increased focus on risk management by domestic financial and non-financial corporates. This is evident in the considerable interest in the development of financial market derivatives," says the SBP report.

Another, particularly encouraging, development in FY04 was the increased integration of the money and forex markets, as the impact of interventions in one was clearly reflected in the other, indicating the improving efficiency in both markets.

"While the capital market is clearly not as closely linked to the other two, it too appears to be slowly reflecting these trends (e.g. recent interest rates hikes have had a discernable, albeit temporary, negative impact on the KSE 100 index)," concludes the report.