Wednesday, June 13, 2012

Uncertainty & Stocks

Khaleej time interview with Nadeem Naqvi, Managing Director, Karachi Stock Exchange


 Q1: How do you see the macro economic situation over the next two years? 

A1: The macro economic outlook over the next two years lacks visibility. There are myriad of factors impacting the macro environment, some domestic and some external. Probable outcomes can range from benign to poor depending on which scenario plays out. A positive scenario could be that international oil prices stabilize and global growth moderates (due to weak demand in developed economies driven by deleveraging of the private sector and growth slowdown in emerging markets as central banks tighten monetary policy). This will help curb inflationary pressures in Pakistan and be positive for the trade account, as bulk of Pakistan's exports are low value added. Alongside this, as global agri-commodity prices stabilize domestic rural incomes and agri-commodity exports would remain above historic levels but incremental benefits would be diminishing relative to FY11. Finally, if some headway is made in improving tax collection and reducing subsidies, fiscal deficit might be contained at 5.5 level in FY12. This would allow the central bank to begin easing monetary policy by 1QCY 2012, enabling private sector growth to pick up. We need to keep in mind that a huge transfer of income has taken place to the rural (and mostly undocumented) economy to the tune of Rs.1.0 Trillion over the last five years due to commodity price increases. If this is sustained and some of it brought into the tax-net, significant improvement in fiscal position is possible. The external account is supported by strong inflow of inward remittances by expatriate Pakistanis, in excess of US$10.0 billion per annum, which is helping to keep forex reserves and the rupee stable.

A possibly weaker scenario would be if the domestic fiscal deficit is not contained and the source of the power sector liquidity crisis not tackled, government borrowing would remain high leading to further deterioration in debt to GDP ratio. Additionally, if there is significant reduction in foreign funding inflows other than remittances, the stabilization in the current account & improvement in reserves may not remain sustainable - especially as large drain on forex reserves will commence in FY12, due to repayments of IMF and other multilateral loans. Add to this increased political maneuvering as we move towards next elections and you have a macro environment which is in flux over the next two years.

Q2: In the presence of high interest rates what incentives do investors have to invest in the equity market? 

A2: No doubt, high interest rates reduce the attractiveness of equities as an asset class. There is a clear inverse relationship between interest rates and equity valuations. However, one should not look at equity investing from a short term perspective. Anyone with an investment horizon of less than twelve months is not really "investing". They are, in my view, better categorized as "trading". There are significantly different strategies when one is trading versus when one is investing as the risk-return pay-offs of the two strategies are very different. Ideally, in my opinion, "investing" means an investment horizon of at least three years. In such a time frame, company fundamentals become the key driver of return for equity investments. For example, analysis of long term equity returns in the U.S. indicate that around 47% of total return is accounted for by earnings growth, 43% by dividend yield and 10% by change in valuation (price-toearnings ratio or P/E ratio). In the case of Pakistan also, it has been shown that over a twenty years period the average annualized return from the stock market has been over 18%, much higher than fixed income return including National Savings Schemes and also higher than inflation. So equities as a reasonably liquid asset class, do provide superior real (inflation adjusted) returns than many asset classes - even gold - over longer time horizon. My message to investors is that they should consider keeping 25% - 35% of their liquid, long term saving in equities as a hedge against inflation. But they need to focus on strong companies if investing directly or go through fund managers who have good track record of at least 3 years, if they are investing via mutual funds.

Q3: Volumes have shrunk to about one tenth from their peak to about 60 million shares a day. Is this due to bad policies of the government or Apex Regulator? 

A3: While the economic (growth, inflation & interest rate) cycle plays a significant role in the attractiveness or otherwise of equities as an investment asset class, government and regulatory policies do have a major role in the growth and development of the equity market of any country. I would not characterize policies as good or bad but rather as appropriate or inappropriate relative to the ground realities. Further, we need to distinguish between government policies and regulatory policies of the Apex Regulator, in this case, the Securities and Exchange Commission of Pakistan (SECP).

Insofar as government economic policy is concerned, my view is that it has failed to deliver in three key respects. First, unwillingness to document and tax agriculture and its supply chain (wholesale & retail service sectors) has shifted huge liquidity into the undocumented sector at the cost of the documented sector. As the undocumented sector traditionally does not invest in the stock market, the shrinkage of the documented sector has had negative impact on volumes & liquidity of the stock market.

Secondly, high fiscal deficit and consequently high government borrowing has crowded out the private sector and kept inflation at elevated levels. At the same time, I believe the central bank has kept monetary policy too tight because significant part of inflation is cost push. Given that 50% plus of Pakistan's economy is estimated to be undocumented, the transmission mechanism of monetary policy is weak in terms of curbing aggregate demand. By draining the documented sector of liquidity the central bank has played its role in adversely affecting the private sector capital market and consequently capital formation and sustainable employment generation. I do not agree with the central bank's position that there is no demand for credit from the private sector. I believe it is banks unwillingness to lend to the private sector because it is so easy for them to invest in "risk-free" government securities and earn extra ordinary interest spread.

Third, imposition of capital gains tax for the sake of imposition without due deliberation of its effect on revenue generation has negatively impacted stock market participation of retail investors who tended to account for bulk of the daily volumes. In India and Bangladesh, individual investors make up 60% - 80% of daily traded volume, whereas in Pakistan this figure has fallen below 40%. It is definitely not the case that market participants do not want to pay tax. What they object to is the cumbersome procedure introduced to calculate the tax and the increased potential of harassment by tax officials whose credibility and accountability is highly suspect. Market participants want a full final tax liability on a withholding basis. The irony is that the government has allowed exactly this facility to investors investing in government securities and it appears unwilling to do so for investors who are actually bearing the risk of investing in equities.

The negative revenue impact for the government of the new tax regime can be gauged by the fact that volume based tax (CVT) netted the government over Rs.4.5 billion from the KSE in 2007, and this excludes tax from insurance companies and banks operating in the stock market. In 2011, the figure is estimated at less than Rs.500 million. A large percentage of retail investors have chosen to stay away from the stock market rather than become enmeshed in the hassle of cumbersome computation process and more than that, come on the radar screen of tax officials, whose real objectives are seen as questionable in the first place.

As far as the SECP is concerned, its regulatory tightening in the aftermath of the 2009 financial crisis is understandable. However, here too I believe that the Apex Regulator - despite good intentions - overreacted and imposed restrictions and conditionalities that have effectively chocked the market and have directly led to volume shrinkage. 25% cash margin in deliverable futures market is one example - nowhere in the world is this seen. Similarly, excluding individuals from participating as financiers in the new margin trading system (MTS) has not helped liquidity either. Thankfully, there appears to be a realization in SECP that the regulatory pendulum has swung too far towards restrictions. KSE is actively engaged with them to bring a balance in regulations such that systemic risk is contained, while investor opportunity set is expanded.

Restoring investors' confidence is the single most important challenge for the KSE and its members and it is also my priority in this assignment as the Managing Director. Several measures have already been taken by the Exchange and the SECP to protect investors including restrictions on usage of investors' sub-accounts at the Central Depository Company (CDC) by the brokers, tightening margin requirements, automated pre-trade verification by the KSE and tighter settlement procedures by the National Clearing Company of Pakistan Ltd., (NCCPL). Put together, KSE, CDC and NCCPL are now electronically closely connected, have enhanced safeguard mechanisms for systemic risks and stronger security measures for individual investors. There is never a fail-safe system but I feel confident that close cooperation of these three key institutions in the Capital Market means that the kind of episodes investors faced in 2008 are unlikely to be repeated in the future.

Q4: What is the KSE doing to arrest the shrinking investor base, especially in terms of investor education and awareness generation? 

A4: The shrinkage in investor base is partially driven by macro-economic uncertainties that reduce appetite for risk assets such as equities. At the same time, it is also a function of general confidence in the stock market as a credible and sound institution. The second aspect is related to reputation and this was damaged in 2008 financial crisis due to unnecessary floor artificially set in the market, first by the Exchange and prolonged by the SECP and under Ministry of Finance pressure, as the latter feared potential run on already weak foreign exchange reserves. This short term attitude by key constituencies led to long term damage in investor confidence. On top of it, a few "bad apples" (6 or so brokers who overextended themselves and then used investors' shares to meet their proprietary liabilities) damaged the reputation of the brokerage industry. Lessons have been learnt from these events. In fact, beyond the above noted safeguards now in place, work is being done on an electronic settlement system where brokers would not have control over investors' shares or indeed, investor funds. They will do what they are supposed to do - focus on identifying potentially good stocks in their research and brokering, period. As such, I believe that it is only a matter of time that retail investors will become comfortable with reentering the market. We also plan to approach the Central Bank to help devise ways whereby the large overseas Pakistani community can easily invest & exit from the stock market without the present cumbersome requirements of SCRA accounts. As an example, India facilitated non-resident Indians' participation in their stock market and this was a big boost. There is no reason why the same cannot be done in Pakistan. There are a good number of high quality companies in several sectors, such as Oil & Gas, Banking, Consumer Non-Durables & Durables, Chemicals that are growing earnings robustly and boasting much superior return on equity than many regional peers. This is a natural universe for Pakistanis resident in the GCC, UK and North America to invest in.

On the part of the Exchange there are several initiatives in the works for generating investor interest. We are working on a project to provide, from the platform of the KSE, summary historic research in English and Urdu on the blue chip companies. This will help small brokers, who simply do not have financial and human resource capacity, to have fundamentals based marketing tools for retails investors. After Ramadan, a series of Road Shows are planned in conjunction with CDC and NCCPL and possibly with Lahore and Islamabad Stock Exchanges, for smaller cities. We are actively working on initiating OPTIONS products by the end of the year with presentations planned for SECP within the next few weeks. The regulations for Market Making have been approved and KSE will soon be approaching financially strong parties for market making in Cash Settled Index Futures and selected large liquid stocks. The regulations for launching Electronically Traded Funds (EFT's) are in final stages of being approved by the SECP and should open a new arena for investors. Most important, we are focusing on early settlement of investor issues & claims that have remained outstanding from the 2008 financial crisis. Out of the 7000 plus claims, 60% have been settled. We want to accelerate the settlement of remaining claims.

The Exchange is considering initiatives in developing the debt market. I do not see KSE as simply an equities market. We have the IT platform and internal systems to support listing and trading of a variety of financial instruments. Recently, with support from the SECP, KSE's Bond Automated Trading System (BATS) has been enhanced. It has been developed in-house and is quite robust. Because the domestic private sector debt market is still nascent and lacks liquidity, we are exploring the possibility to tapping into the govt. debt market, which is both deep and highly liquid. I am confident that many of the above initiatives will be executed over the next six to twelve months and help restore confidence and vibrancy in Pakistan's Capital Market. On the international front, several Road Shows are slated for key investment centres around the world from September to November. We have also been in discussions with MSCI to consider putting Pakistan back into their Emerging Markets Index from the present position in their Frontier Market Index.

Q5: New listings have been very few in recent years. High interest rates would normally attract more companies to the capital market to raise money - why is this not happening in Pakistan? 

A5: New listings have indeed been low in the past few years having reached 17 in 2006, falling to 13 in FY10 and now have fallen to just 3 in FY11. High interest rates are just one of several factors that go into the decision making process of a company contemplating to list itself on a stock exchange. In economic terms, we need to remember that debt-finance actually provides a tax-shield to the debt issuing company because the cost of debt (interest) is treated as an expense in accounting terms, so income is reduced and therefore tax is reduced. Companies look at after tax cost of debt and compare that to the cost of equity, which is actually not zero but linked to the so-called risk-free rate (on govt. securities) and has an additional percentage (premium) to account for equity market risk. Finally, a weighted average cost of capital (debt+equity) i.e. WACC is arrived at which is compared to the return on capital (ROC) generated by the company. At the simplest level, a company will raise new capital only when ROC is greater than WACC.

Besides the bit of "finance theory" highlighted above, there are other factors determining new listings. If liquidity in the stock market is low then companies may be reluctant to list because price discovery (i.e. value) of their shares could be inefficient, or they may be worried about cornering of their company's stock. Then there is an issue of cultural mores. Many family owned companies in the country shy away from publicity and many are worried about regulation related to listed companies which require greater transparency and more stringent corporate governance. Here, I believe the stock exchanges do need to create awareness amongst potential "listable" companies that net-net, the benefits to the family wealth by listing outweigh the perceived costs/downside of transparency and governance. I believe that the world has already entered a new era of corporate governance and companies that are not transparent will find themselves at increasing competitive disadvantage over time. This is particularly the case for companies that are exporting as their buyers will increasingly demand greater transparency. Listing on stock exchanges provides such transparency and gives buyers and financiers greater confidence when dealing with listed companies. In my view, it is only a matter of time that SECP regulations become more and more stringent for corporate entities that are not listed. The recent budget has given some tax incentives for companies established on an ALL-EQUITY basis. For small to medium enterprises this may be useful but for larger companies or those whose projects are large, all equity finance may not be possible. The effect on new listings is likely to be negligible under present rules and regulation where minimum equity capital requirement is Rs.500 million in order to list. We are however, studying the possibility of reactivating the over-the-counter (OTC) market which has less stringent listing requirements as well as much lower capital requirements. This would enable medium sized enterprizes to list. In the first instance, we plan to identify specific high growth sectors and discuss the potential of listing with companies in those sectors, with emphasis on export oriented sectors. This exercise may take a few months but I believe it will yield positive results and result in new listings from the SME sector.

Disclaimer: Investing in stocks & shares carries various risks, including loss of the principal amount. Investors are advised to conduct their own research before investing or take advice from professional investment advisors.

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