The financial markets are maturing, distortions are being removed but they lack depth and are handicapped by limited avenues for investment.

After a prolonged lack lustre performance, the stock market now suffers from aberrations. It lacks retail investors. Company managements tend to hold 50-55 per cent of equity that reduces the volume of tradable shares.The core-income stocks are few compared to listed firms. Corporate culture leaves much to be desired.

But yields from investments are still higher compared to bank deposits and national saving schemes (NSS).

This is how the president of the National Bank, Mr Ali Raza, describes the changing trends in the financial market.

Over the past few years, there has been a shift in the pattern of business and industry raising capital from different sources but bank borrowing has retained its overwhelming position.

Currently, reckons Ali Raza, an estimated 85-87 per cent of the borrowing is through banks, 10 per cent through corporate debts (Term Finance Certificates) and 3.5 per cent funding is from equity.

In developed economies like the USA, the ratio is of one-third for each. The stage of development of the market is indicated by saving flows and capital raised through different vehicles. The scheduled banks have a deposit of Rs1.6 trillion, stock of the NSS certificates are worth Rs850 billion and corporate bonds are valued at Rs35 billion. Despite the financial sector reforms, the private sector is heavily dependent on bank borrowings.

When looking at options for raising capital in low interest environment, the business does not want equity investments. There is no retail investment. Firms avoid cumbersome procedures for listing at stock exchanges prescribed by bourses and the SECP. A business executive says, “Cost of debt is cheap. So, it is wise to avoid a plethora of legal and other formalities for listing.” This has placed disproportionate burden on the banks.

The average lending rate is as low as seven per cent. But banks lend to corporates at two per cent, 70-80 basis points above the treasury bill rate. The low interest rates are explained by the fact that the banks and non-bank businesses are awash with liquidity. And the liquidity continues to pile up on account of reverse flight of capital as one banker reckons the demand is just 40 per cent of the supply.

Multinational donors also point out that industry and other businesses have borrowed heavily to replace costly debts by cheaper borrowing. Private sector borrowing went up by Rs130 billion last year and Rs40 billion in the previous year. Corporate profits have jumped and there is some hope that there would be a turnaround in domestic investments as corporate profits, savings and the enabling environment for business have improved.

A banker reckons companies have saved several billion rupees on low priced bank loans and corporate debts. The borrower is gaining from the business cycle. Savers are losing in the low interest rate environment.

With interest rates on NSS certificates lowered and sales restricted through Central Directorate of National Savings (CDNS), savings are flowing into shares and property.

The integration of the financial market is gradually phasing out fixed return investment schemes which are being replaced by investment with varying degrees of risks and rewards.

Institutions, including pensions funds, have been debarred from investing in the NSS since December 1999. Pension schemes have always been restricted to big corporations and leading banks. They are finding it difficult to invest in a low rate environment. Investment of pension funds brought lucrative return from the NSS. The avenue is not available. It has become a major issue for banks and corporates as where to invest pension funds whose yields could match the liability. Return is much less and liabilities are the same.

A senior banker says that the dramatic change in the situation is prompting institutions to consider moving away from the pension fund to provident fund in order to remove the ongoing liability. Looking at investment options, corporate debt is too small and the listed core-income stocks are too few. Pension funds can be invested in very few shares with a track record and definitely not for capital gains. TFC yields are getting low as prices are going up.

Ali Raza says that there is overheating in the KSE. Equity structure is lopsided. Far more number of companies are opting out of the market than getting listed. Many are being de-listed. Stock prices in development markets are sensitive.They are real economic value for any company. Stock options for employees improve labour productivity and keep shares prices high. In mergers and acquisitions, “stock swaps” benefit the higher value stock held by a company. For stock options, it is essential that at least 80 per cent of the shares are traded and only 20 per cent are held by the management/sponsor.

Policy makers are trying to divert savings now flowing into the pension funds, provident funds and other such schemes of employees terminal benefit, towards development of mutual fund industry. Mutual funds are growing, their aggregate investment has touched Rs43 billion. The SECP officials estimate there is huge potential to raise the investment to Rs100 billion. But the mutual fund industry is yet dominated by state-run NIT which enjoys a market share of 65 per cent because of its large portfolio and efficient operations. The NIT has not only outperformed the benchmark of KSE-100 share index but also managed to outperform every mutual fund during fiscal 2002-2003.

Recently, Mr Tariq Iqbal Khan, managing director, the NIT, received an award by the Mutual Funds Association of Pakistan for his organization’s outstanding performance.

Of course, the number of mutual funds are gradually increasing. An open- ended Meezan Islamic Fund is expected to be floated by the end of this month. The seed capital of Rs520 million has been contributed by financial institutions, insurance companies and provident funds.

Mutual funds offer three basic options to savers according to their risk and investment profiles. In Pakistan’s context, says Ali Raza, it could be as follows: High risk and high return (10-11 per cent), medium risk and medium return (7-7.5 per cent) and conservative risk and return (3-3.5 per cent).

Bankers fear cannibalization of bank deposits by a growing mutual fund industry. The official focus on development of mutual fund industry is a wake up call for the bankers. And to quote a banker, it would be of immense benefit for bankers to float mutual funds. Comfortzone for banks is coming to an end. In the USA, mutual funds are 112 per cent of bank deposits.In current situation in Pakistan,the Rs43 billion mutual fund does not compare so favourably with bank deposits of Rs1.6 trillion.

But the threat is looming large as the official policy is to divert long-term savings flowing into NSS certificates to the Mutual Funds managing pension funds that could be used for mortgage finance and housing development.

This effort is being supported by a broad range of tax incentives for listed mutual funds including exemption from payment of withholding tax on their income from dividend , brokerage or commission etc. Non-profitable organizations have been permitted to make investment of unutilized funds in any mutual fund. Previously, these institutions could only invest in government securities.

But the key issue facing the financial markets, awash with liquidity, is the limited avenues for investment, which requires a rebound in real economy.