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Researcher: Prof. Khurshid Ahmad

Researcher: Hafiz. A Pasha S. Fazle Hassan

Introduction

 The financial system in any country consists of a large number of institutions, instruments and markets. Financial intermediaries range from money lenders and commission agents to banks, insurance companies, brokerage house, investment trusts and stock exchanges. Financial instruments (or assets) range from coins and currency notes to government bonds, mortgages, corporate stocks and the more exotic derivatives of high finance. Markets dealing with the trading of financial assets can be categorized as being either formal (as in stock exchanges with centralized trading floors) or in formal (as in over the counter or curb markets).

The objective of this paper is to highlight first in broad terms the role of financial systems in economic development and then to focus on the specific contribution that stock markets can make to the widening and deepening of the financial sector. We then describe the evolution of stock market in Pakistan and high lighted in particular the factors which have the constrained effective operation of equities markets in the country. Finally we make recommendations for enhancing the role of stock markets.

 2.                 The Role Of Financial Systems In Development

 2.1        Role Of Financial System

the basic role of financial systems is to engage in the process of  intermediation by mobilizing savings from a large pool of small savers and channelizing these funds into productive investments by a generally much smaller number of borrowers. The key to success in intermediation rests on the ability to pool together and thereby reduce the risks associated with individual investments.

 In the absence of financial services, an economy is relegated to activities of subsistence or barter. This greatly limits the scope for specialization and the achievement of economies of scale through operation of modern, large scale technology. Also it is not possible to separate the timings of consumption from production unless physical inventories of goods are build up. Altogether, economies with underdeveloped financial systems are likely to have lower incomes, other things being equal.

 There is general recognition now that finance is the key to raising the level of investment and savings and there by promoting the process of economic growth. Channelizing saving to investors with more productive uses for them enhances the income both savers and borrowers. Without an efficient financial system, lending can be costly and risky. Competition among financial institutions ensures that transactions costs of intermediation are minimized, that risk is allocated to those most willing to bear it and that the most promising investment opportunities are discovered.

  2.2            Evolution Of Financial System  

Traditionally, financial system of developing countries have been dominated by informal finance, consisting primarily of loans from family members or friends or money lenders. Such managements have had the advantages of low transactions costs, responsiveness to borrowing need frequently for emergency consumption purposes and low rates of non-repayment. However, they have greatly limited the scope for financial intermediation due to the largely personalized nature of the contacts. It is clear that as economies grow, thes arrangements need to be diversified and supplemented by the services that only formal institutions like commercial banks and capital markets can provide. For example by transforming the size and maturity of financial assets, such institutions can more effectively mediate between the many small savers and depositors who prefer liquidity and the few large borrowers who need long term loans to finance investment. The emergence of financial institutions not only potentially raises the volume of savings by offering higher rates of return with relatively lower level of risk but also changes the composition of saving away from physical assets like land, property, jewellery, etc, towards financial assets, which enables more productive investments to be undertaken from the overall economy point of view. Thin increase in financial assets is referred to as ‘financial deepening’.

  2.2          Polices In Financial Sector 

In the initial stages of development of the modern, formal financial sector most countries, including Pakistan, have chosen the path of controlling interest rates, directing and rationing the allocation of credit to priority sectors and using the banking system for inexpensive funding of government activities. This has undermined the process of financial development and led to ‘financial repression.’ Saving have depressed and other distortion have been created, including the strong preference for debt versus equity financing of long term investment in the presence of regime of low interest rates. Also, this has resulted in a degree of ‘financial distress’ due to low spreads and default in repayment of directed loan. Simultaneously, the preferential access to credit of the public sector has tended to ‘crowed out’ the private sector.

  2.3          Financial Sector Reform  

Recognition of these problems had led many countries, including Pakistan, to pursue the path of financial liberalization in recent years. There has been extensive deregulation of interest rates, concessionary credit schemes have been phased out, government owned banks have been privatized, terms of government borrowing have been linked more closely to market rates and permission granted for the establishment of new types of financial institutions (investment banks, leasing companies, mutual funds, etc.) in the private sector and removal of restriction on foreign portfolio investment. These reforms promise to enhance the role of capital market in particular in the financial system. We turn now the role of equities markets in the process of development.

  3       The Role Of Stock Markets

The primary role of stock markets is to provide long term equity finance for the corporate sector. Trading in equities enables intermediation between conflicting maturity preferences of lenders and borrowers. Stock market also potentially promote broad-basing of ownership of financial assets and the reallocation of funds among corporations and sectors.

  3.1          Choice Between Debt And Equity

The management decision regarding choice between debt and equity modes of finance is contingent on a number of factors which include risk and cost of capital. Under a private enterprise system the prospects of individual gains are inevitably associated with the possibilities of loss, and this hazard rests on those who have supplied the capital. The hazard shows itself in the form of uncertainty both of income to be received and recovery of principal invested. It is these uncertainties that constitute risk.

If a corporate entity fails to earn a profit and continues to spend more money than it takes in, a time will come when it will be unable to meet its current obligations.

When that happens the company becomes insolvent or bankrupt. In such situations all debts must be settled in full before any equity claims can be paid.

Because of the priority of debt claims before equity claims the creditor is ready to supply long term capital in the form of debt at a lower cost in the form of  interest. The creditor, therefore, does not demand a proportionate share in profit. It may be pointed out here that the position of a creditor is negotiated one as a result of a bargain between the firm and the supplier of the funds. The decision of accepting a particular level of risk, there fore is voluntary on both the sides.

If we compare debt and equity securities from the point of view of allocation of income, holders of debt securities have to be satisfied with low and fixed incomes. These instruments also enjoy stable market values because of lower risks. on the other hand there is lot of variation in the income of equity security with the result that the price performance is more volatile resulting in the higher degree of risk. In accepting this higher level of risk, equity holder on the average expect a higher rate of return.

The mix of debt and equity, that is, the capital structure differs from industry to industry. Industries with stable sales performance and stable margins (selling price-cost relationship) permit use of more debt. On the other hand, an industry having less stable sales performance and volatile margins may have a lower debt to equity ratio.

Therefore, companies in stable sales industries will enjoy lower cost of capital compared with companies in volatile sale performance industries. Also the capital structure affects the stock market performance of the shares of company. A company using more debt than the industry averages may have lower share price because of higher risk. Use of more debt may result in higher earnings per share but they may be offset by increased risk, resulting in an adverse price effect .

The mode of financing used is also influenced by the motivation to keep control. A firm may avoid issuing new equity for fear of dilution of control and, therefore, the growth requirements may be financed through internal equity (retained profits ) only. Debit may also be used when this source falls short of the requirement. This could result in a firm moving away from the optimal debt to equity ratio.

  3.2          Equity Markets And Development

Broadly speaking there appears to be some correlation between indicators of development of equity market in a country and its overall level of development, as shown in table 2.1. The table indicates that, as of the late 1980s the equity market in Pakistan was relatively underdeveloped. The position has improved significantly in most of the emerging markets in developing countries, including Pakistan, in the 1990s, following the process of financial liberalization and, in particular, due to the flow of portfolio funds from developed countries of these emerging markets. As such, while ratios have improved the relative standing of Pakistan has not improved dramatically.

  3.3          Constraints In Development Of Stock Markets 

A number of factors have traditionally been responsible for the under development of the equity market in Pakistan. We have already referred to the government policy till recently of keeping interestrates artificially low, thereby leading to a strong preference for debt versus equity financing. Also, the tax system has increased the attractiveness of debt and firms have remained highly leveraged in Pakistan.

                                                             Table 2.1

                             Equity Market Indicators (1987)

Per capita               Average market                       Turnover ratio

Income                          Capitalization                           (% of average

                        (US $)                          as % of GNP                            capitalization)

 Developed Countries

Japan               15760                          92                                            93

U.K                 10420                          80                                            72

U.S.A              18530                          58                                            93

Germany            14400                          21                                            161

France              12790                          18                                            56

 Developing countries

Malaysia            1810                            58                                            23

Korea              2690                            19                                            111

Thailand            850                              9                                              114

Mexico1830                             8                                              169

Phillipines            590                              7                                              62

India                 300                              6                                              19

Pakistan            350                              5                                              9

 In addition, there have been negative perceptions about the operations of the stock market on the part of small investors. For a stock market to perform its role efficiently, it must be transparent and market based.            The average investor in Pakistan sees the market as being dominated by insider trading, frequent conflicts of interest and low rate of payment of dividends. There is relatively weak regulation and supervision of companies and reliable financial information is generally not disseminated. Further, the stock remains very thin and only limited quantities of corporate stock are traded as sponsors are generally unwilling to dilute their ownership. Consequently, there is great deal of volatility in share prices, which frequently do not reflect accurately the underlying fundamentals. The procedures for trading the stocks also impose high costs and are cumbersome in nature. Altogether, the role of equity markets can be enhanced only if the stock exchanges operate efficiently in a competitive framework. 

 3.3          Recent Stock Market Development

The boom witnessed during the 90’s in the stock market of Pakistan can be attributed to a large number of factors, including, first, the process of financial liberalization resulting in a rise and inflow of foreign portfolio investment; second, the process of privatization and the offering of new attractive shares; third, a greater measure of political stability and investor confidence; fourth, improvements in the operational efficiency of stock markets. It is of significance to note that the two major measures of the share price index coincided with the induction of popularly elected governments in 1990 and 1993 respectively. More recently, prices have plummeted in response to weakening in the underlying macro economic fundamentals, deteriorating law and order situation and exodus of foreign portfolio capital.

The experience of the last years demonstrates that while the process of financial liberalization and deregulation has conferred large capital gains in terms of the increase in market capitalization (of over ten times between 1989 and 1995), the result remain fixed. First, there has apparently been an increase in the volatility of the stock market, with large increase being followed by big decrease. For example, share prices rose by as much as 48% in 1993, but have fallen since by 40% (see table 2.2). This volatility is not only the consequence of underlying law and order and political factors but also a reflection of relatively short term nature of inflows of foreign portfolio funds. These fluctuations in share prices have increased perceptions of risks and run the danger of driving out risk averse investors from the market, resulting in a degree of disintermediation. Second, while market capitalization.

 Table 2.2

Index Of Share Prices In Pakistan

Year                 SBP general index                            percent

                        Of share prices                              Annual change

                        [1980-91=100]                                                                                                

1981                            93.5                                                     -

1982                            100.3                                                   7

1983                            131.6                                                   31

1984                            182.4                                                   39

1985                            176.3                                                   -3

1986                            171.0                                                   -3

1987                            222.7                                                   30

1988                            260.6                                                   17

1989                            273.3                                                   5

1990                            283.5                                                   4

1991                            387.7                                                   37

1992                            334.0                                                   -14

1993                            493.1                                                   48

1994                            589.6                                                   20

 has increased rapidly, only a fraction is due to listing of new shares. At its peak in 1992, stock markets in Pakistan mobilized capital of about Rs 12 billion through new issues. This is equivalent to only about 10 percent of private investment in Pakistan. Therefore, the role of equities market in mobilizing funds of investment in plant and equipment remains very limited. Further reforms are required for an enhancement in the role of Pakistan. We turn to these in the next section.

Based on the above, we present some recommendations for enhancement in the role of stock markets. In the context of choice between debit and equity we have highlighted that firms are highly leveraged in Pakistan. It is essential that the access to debt financing from commercial banks and DFIs be reduced by requiring these financial institutions to target for lower debt to equity ratios of 60:40 or even 50:50. as opposed to this, appropriate regulatory changes may be introduced so that floatation of corporate bonds directly in stock market are encouraged, especially by multinationals and other large corporations. Other proposals generally to the development of better financial infrastructure for operation of stock markets. These include strengthening of regulatory provisions and better enforcement, improvements in information systems and mechanisms for payments, more neutral application of fiscal policy (especially with regard to income and wealth tax) to all types of financial instruments, higher standards of disclosure of financial information by companies, improvements in auditing and accounting practices and greater scope for financial innovation within a flexible regulatory framework. We expect that progress in these areas will enhance substantially the role of stock markets in the economic development of Pakistan in coming years.

Researcher: Mian Mumtaz Abdullah

The 1990s have seen the emergence of a number of countries including  Pakistan in the capital market. During this period four main ideas have dominated its development. First, the privatization of public sector units gave a boost to the capital market especially in mexico, Malaysia, Pakistan, Philippine and India. Second, the capital market was opened to foreign investors through its internationalization and hence it encouraged the foreigners to make direct investment in a number of south asian countries. Third, due to the fall of soviet union and some other socialist countries, the command economies were transforming into the capitalist system. Along with other changes, the transformation also led to the emergence of new capital markets even in china, Vietnam and Mongolia, the citadels of the socialist system. Finally, the tremendous increase in the services for trading, settlement and depositing system and the introduction of automation and computerization of stock exchanges accelerated the emergence of capital market.

 The present paper deals with the performance of stock market in Pakistan. To make the discussion more systematic, it is divided in to two parts. The first part deals with the capital market till the end of 1994. the second part is concerned with the recent developments in capital market since January 1995.

The growth in market capitalization was slow in eighties. It was 0.317 billion dollars in 1981 rising to the 0.833 billion in 1985 and reached 1.982 billion in 1990. at the end of 1994, the market capitalization is almost 44 times mare than that was in 1980. the performance of capital market is elaborated in table 1 where annual turnover of shares Is presented.

                                                     Table  3.1

                             Annual Turnover Of Shares

1987       157,298,550

1988       169,263,025

1989       214,571,710

1990       255,396,705

1991       616,914,235

1992       799,336,000

1993       1,276,312,000

1994       1,770,526,0

 in 1987 we had an annual turnover  of 157.30 millions. In 1990 it went to 255.4 millions. Then from 1991 onwards the increase in the annual turnover was very steep reaching 1.77 billions in 1994.These figures indicate that since 1989, on an average, there was about 1.2 million daily turnover of shares.

 Table 3.2 gives us for four years, 1990-1994, the month wise picture of stock market both in KSE and SBP indices. The KSE index started rising in the beginning of 1991 but in December 1991 it fell abruptly. The KSE remained fluctuating around 1200 during the first quarter of 1992. however, it rose from12969 to 1545 in June 1992 and again started coming down gradually till June 1993. at the end of 1993, it started rising again and touched the peak in April 1994. it started coming down after that till the end of 1994. a similar trend can also be seen in the state bank index. The companies listed were 487 in 1990 and kept on increasing reaching 764 in December 1994. the number of listed companies was the highest, eighty six, in 1992 and then 73 in 1994.

 A comparison of the four years KSE and SBP indices reflect that the capital market performed well by the end of 1991 but remained in low profile during 1992 and 1993. it picked up in 1994 reaching the peak in april 1994. however, since October 1994 the index started falling reaching 1630 in april 1995. what are the factors that made the Pakistan capital market perform so well? First, Pakistan despite the balance of payments difficulties and fiscal deficit problems has enjoyed reasonable degree of macroeconomic stability. The average GDP growth rate has been around 5% but most important was the perception of foreign investor about the economy which was very favourable particularly during 1994. second, and the more important factor, was the radical policy of liberalization and opening of the entire economic system and the financial sector in particular. Perhaps the more significant development in last three years has been the measures taken by the government to replace the age-old system of administered interest rate structure, quantitative credit control system by market oriented interest rate structure and open market operation for the management of the monetary system. These macroeconomic policy measures have been accompanied by deregulation and relaxation of sanctioning procedures. The third factor which has a direct impact on boosting the securities market is in the realm of exchange control regime. With the exchange control regime liberalized, a number of incentives were given to domestic investors and foreigners were allowed to come in.

 The fourth factor which has been critical to the development of capital market is the expansion and development of corporate sector. Securities market can grow in an environment with encourages the incorporatisation of investment and business activity. It is not only necessary that more companies should come into service but companies should grow in size, so that there is compulsion to seek funds from public. Though this process is linked with the overall development of the country, policies of government can also accelerate the process. A number of measure were taken such as the extension in capital gain tax exemption for another two years and introduction of a simplified tax system.

 The fifth factor is, the sustained supply of securities either through new issues, disinvestments or the right issues. All these there have been followed in Pakistan. Not only new issues have come, the government has disinvested some of its units and right issues have been forthcoming as well. The sixth factor in this connection is the nature and character of the regulatory framework. The key element of such system is a comprehensive institutional arrangement for the protection of investors, based on requirement of transparency of transaction and code of behavior of market participants. Although we may not have done much, but steps were taken towards this direction and still to be taken not only by the regulatory authority i.e CLA, but also by the stock exchanges themselves. Self regulations have come in to existence and stock exchanges themselves regulating their affairs to a greater extent. Of course there are drawbacks in the system and we need to make them perfect.

 An inhibiting factor is the slow moving legislation system of Pakistan. For example, the company law of 1956, after its revision in 1979, was submitted to the government in 1980. it took four years for the national assembly to pass the revised company law. New regulations affecting securities and the company’s law in 1992 and 1993 have been to the submitted to the government, which are still awaiting presentation in the assembly. If we wait for inordinate long periods for the legal approval in a world which is moving at a fast pace, we are bound to be left behind.

 Before ending discussion of this part, let us look at the composition of stock market table 3.3 gives the comparative view of the number of companies in 1991 and 1994 in different sectors of the economy. The comparison is made by looking at two aspects, the number of companies in different sectors and the change in their paid up capital. The figure reported in table 3 reflect that the services sector like banks, the finance, mudarbas, and insurance have increased from 16.36 percent to 25,43 percent while the manufacturing sector has gone down.. this is a very significant factor. The stock exchange will increase its volume, if a strong manufacturing base is provide. Unfortunately, we are manufacturing base. This, of course, is because of the high interest rate and high infrastructure cost.

Another thing to look at in table 3.3 is transport and communication sector. It remained 10 percent of the total paid up capital in 1994. in terms of absolute amount, because of PTC, it has increased tremendously. The total paid up capital of PTC was 4.773 billion in 1993 and 11.529 billion rupees in 1994. hence the PTC is dominating not only the communication sector but is influencing the overall capital market.

 The second part of this paper is to analyze the performance of stock exchange since the beginning of 1995. in table 3.4 a weekly review of KSE index (on every Monday ) from the second of January till the third week of April 1995 is presented.

 The table shows that the biggest fall came in the third week of march (of about 134 points). Along with the fall in index, there was fall in market capitalization.the market capitalization was Rs.404 billion on 2^nd of January 1995, which dropped to Rs.360 BILLION ON 30.1.95 thereby losing about Rs.44 billion in one month alone. Even though capitalization rose in February to Rs.379 billion did not reach the level as of the beginning of the year.

 What are the reasons of this tremendous fall of stock market in the last few months? There are following possible reasons of this deterioration. First, it started with the devaluation of Mexican peso and the rise in interest rate in USA and the consequent flight of international investors from the emerging economies. The second factor of this deterioration has been the liquidity crunch. A number of mega-issues, like PTC, hub co,

And others were brought in to the capital market, which took away all the access liquidity (whatever was there in the economy). This was augmented by uncapping of the interest limit by the state bank of Pakistan. The third factor has been the effectiveness of prudential regulations. These regulations are the good measures for the capital market but we can relax them looking at the downturns of the economy. They should move along with the economy. Unfortunately, the laws are very rigid and their interpretation does not provide due flexibility. The fourth factor is that since 1970s we have hostage to revenue collection with the result that other policies have suffered. The stock exchange markets are also adversely affected by this action. The result is that stock exchanges themselves are not getting sufficient funds. Finally, and the most important factor is deteriorating law and order situation and growing political instability – two vital factors which adversely affected the stock market.

Yasir Mahmood

Trends in stock market are usually observed by looking at a number of quantitative indicators, such as number of companies, listed capital, market capitalization, average daily turnover and average daily volume of trade. These quantitative indicators may very well be termed as causative factors because all these indicators have cause effect relation on one another. During 1994, all of the quantitative indicators show a positive trends and only market capitalization was declining in all three stock exchanges. Following is the brief discussion of each of these indicators:

 1. Number Of Listed Companies

Historically thenumber has increased  in all three stock exchanges. In KSE it has increased from 15 in 1950 to 748 in 1994. but the actual number of companies has to be compared with the listed companies in Bombay stock exchange .BSE has more than 7000 companies today. KSE has also such potential in terms of increasing the number of companies keeping in view the fact that the number of private limited companies in Pakistan today are in the range of 25,000 to 30,000.

 2.Listed Capital

The listed capital in all stock exchanges show an increasing trend during 1994. historically, listed capital in KSE has increased from Rs. 117.315 million in 1950 to Rs104 ,137 million in 1994. recently the concept of 100 percent equity based projects are coming to the stock exchanges. It is a positive thing giving the fact that traditional sources of capital are getting crowded out. This is a positive development but also the need of the hour is that in a project with debt and equity, it goes through a phase of diligent evaluation from all angles, where as 100% equity based project does not go through that phase of evaluation by the financial institutions.

 3.Market Capitalization

 This is the only indicator which has shown a decreasing trend during 1994. over the time, market capitalization of KSE, has increased from Rs.1871.4 million in 1960 to Rs.398,912 million in 1994. Factors responsible for the recent decreasing trend, are both internal and external. External factors include international factors as well as the domestic factors, like law and order situation and political instability. The most important factors, however, is internal. The important thing is that it is a self-adjusting process. If market capitalization goes down, companies coming for the listing automatically slow down because of the anticipation that they may not be subscribed. There was also too much supply of shares and the absorption capacity of the investors, particularly the local investors were not there to take that much supply.

4. AVERAGE DAILY TURNOVER

 Average daily turnover percentage also shows increasing trends in all stock exchanges in 1994. Today average daily turnover at KSE is around 17 million shares which was previously between 7 to 8 million shares. This is about two-fold increase . At LSE, it seems more phenomenal where average daily turnover increased from 4000 to 5000 to approximately 5 million shares, a ten times increase. ISE, similarly, has seen a huge growth in terms of volumes. This growth in turnover brings the much needed liquidity. It again makes the market more attractive, both for domestic and foreign investors. The importance here is to look at the quality of this turn-over. At this point in time, quality of turn-over is mainly jobbing which is not a healthy trend. It has to be order driven. Concentration of market driven firm investors is another concern. Today, 80 to 90 percent of the volume is moving around 5 to 6 groups. That is also not a healthy  trend and has to be looked at.

 5. AVERAGE DAILY VALUE TRADED

 Average daily value traded has gone up and practically every where in the world where capital market has developed, the market participants and the members make money, because if they make money they expand and further deepen the capital market. So it is imperative that all the policies are directed towards this and that they are allowed to grow. There are different growth strategies that one can talk about. One is the opening of the stock exchanges, the other is allowing the existing member to branch out, the third is opening up the sub-brokerage hoses. Each strategy has to be properly looked at and one must have justified criteria, if one is to develop further stock exchanges. Specially so when companies listed on the three stock exchanges are same.

 6. MEGA PROJECTS

 Pakistan stock market has seen a new concept which was previously unknown, and that is of mega-projects. PTC, Hub-Power, Faisal Bank and Lucky Cement are examples. This advent of mega-projects has lot of implications

 1.                 It has increased the liquidity aspect which was problem at LSE and ISE and was the problem of international :investors. Now there are 4 to 5 companies which are practically dominating the turnover at three stock exchanges. This is however, not a negative trend and had to happen out of necessity.

2.                 Another  implication of these mega-projects is that companies with smaller floats will practically dry-out, and our stock exchanges would be operating basically with the four or five companies of bigger floats. One must classify the shares according to the activity and size; that is imperative. That more time should be given to these shares and at the same time, they should be more closely monitored. Consider the example of London Stock Exchange where they have classification of shares in Alpha, Beta and Gamma, which is actually the classification of shares according to the activity and size.

3.                 These mega projects have contributed a lot towards increasing the saving rates, because the way they were advertised, has its implications. And also because the costs associated with relative size of the projects are small.

4.                 This experience can act as a progressor for our stock exchanges to become international in the sense of offering service to countries like Central Asian states, where capital markets do not exist.

7. GLOBALIZATION

One must look at the present global environment which is characterized by private capital. Gone are the days when the reliance was on official capital like World Bank and IMF grants. It is the era of private capital and one must take into account that the entire world, right from the Latin America to Eastern Europe, pacific rim countries and the entire South Asian region is hungry for this private capital. We are in a  very competitive environment and all our policies have to take into consideration the steps being taken by these capital starved economies. Recent global turmoil in financial markets out the theory in question which advocates for diversifying the portfolio globally. An important phenomenon is that markets today are open in the sense of having linkages with international events. Our market has to be prepared to take care of these things because institutional investors unlike the individual investors show this herd behavior. There are 15 or 16 institutional investors who act as the trend setters and all the others smaller institutional investors follow them. If emerging markets are invoked, all of them would step in. if these markets are going down, out of fashion, all will go down. So that is the tend one has to look at.

 The short term liquidity, that has come in our markets, is double-edged in the sense, that if it Is drawn suddenly it will have disastrous consequences for our economy.

 8. CROSS BORDER LISTING AND FLOATATION

 Cross-border listing, like PTCL, global depository receipts and offering outside Japan in recent time, to the extent that it has introduced Pakistan to the international investors which were not known before. But there are lessons to be learnt from this. In India, for example, there are about 55 such instruments, GDR’s convertible bonds and other issues with no feature of convertibility. PTC has a feature of convertibility and an arbitrage taking place between the International market and our local markets. As a result all the money has been skimmed away. This is something to be looked at and to decide whether we need this convertibility feature in international listing or not.

 With rising volume, another event that has been observed is that trade between the local stock exchanges has gone up. Originally this trade was one way, from Islamabad – Lahore to Karachi. But with this liquidity a two way trade is taking place. And again arbitrage is something to be exploited and again another lesson to be learnt  is that of barring scandals. It was while arbitrage that was taking place between Tokyo and Singapore, that the crisis happened.

 9. DEBT INSTRUMENT

 debt Instrument is a new development to our market. It lowers the cost fort he investor, and is a very efficient allocation because it takes away the intermediary, and borrower and lender can interface directly.

 10. VOLATILITY

 Volatility is very common in stock markets. Speculation is not all bad. It plays a very crucial role by providing a liquidity and continuity of prices to the shares. Since speculation has certain advantages, it should be optimal. We may not have over regulations so that growth is killed, nor less regulations so that speculation becomes rampant.

Researcher: Tariq Iqbal

The PHENOMENON of foreign investment in general should be seen as another link in the chain of capital exchange relationships which have emerged between the developed and the developing world in the post-decolonization period. The flow of capital from the developed world to the developing one was, to start with, a political need of the capitalist world which was looking for ways and means to curtail the spread of Communism. Therefore, a mechanism of providing grants, aid packages and loans to the third world countries through bilateral agreements or through international institutions, such as the IMF and the World Bank, was evolved to implement the western developmental model in these societies. And this mode of economic transaction among nations is still prevalent, though now it is not pursued with as much enthusiasm as it was done in the bygone days. Moreover, quite often than not, the terms and conditions of such aid packages and loans has also proved to be counterproductive for the recipient economies. This very basis of this model have come under serious questioning and foreign investment, rather than loans and aids, is now considered as a more desirable procedure to muster the capital needed for economic growth in the developing countries. Thus, foreign investment has now become a buzzword and it is generating unprecedented euphoria in the third world - especially in Pakistan.

Broadly speaking foreign investment has two categories : direct investment and indirect investment. While dealing with indirect investment we are invariably referred to the investment which is done through the stock market. Now, for a developing country like Pakistan where capital resources are scarce, foreign investment is almost an ideal mode of accumulation of capital badly required for launching developmental projects in various sectors.

As compared to direct investment in such projects, foreign investment through stocks is regarded safer and often more profitable for the investors. This is so mainly because of two reasons : Firstly, favorable exchange rates, and relative strength of the foreign currency as compared to that of the host country, minimize the risk of their investment s turning bad and this is true for both short term and long term investments. Secondly, the level of control the foreign investors enjoy over their shares investment in particular and over the trend of a stock exchange in general provides them more room to make appropriate decisions.

The last part of the argument, however, can also be used to highlight the adverse effect that foreign investment may have on the functioning of a stock exchange. The equity market trends to follow the pattern set by the foreign investors and moves into bearish or bullish groove depending on the interest shown by the foreign investors and the overall atmosphere that they create in the market by large scale paring in of the capital of its massive with drawl. Here, we have to consider this pertinent point being highlighted every now and then by our local market investors and the press that the current decline of the market since middle of 1994 to date is the result of withdrawals by the foreign investors. If this point is considered in its proper perspective, we would like to argue that the KSE index, which stood at that time at 1050, started to rise from the middle of 1993, picked up gradually towards the end of the year and rose to an all time high mark of 2662 by July 1994 and then started to decline.

It has been argued that. Besides other factors, the flow of foreign investments in that period was instrumental for that phenomenal rise and withdrawal of foreign investment was the cause of decline of the stock market form the middle of 1994 onwards.

It is quite natural for a large number of investors � whether foreign or local � to invest in a rising market and there would be a selling pressure in the declining market. In the latter scenario, local investor would also like to dispose off his investment to minimize his losses. The foreign fund manager is a trustee of those investors who have invested through him and he is duty bound look after the interests of his depositors and investors and if the market is declining then there would be a selling spree which is quite natural. The foreign fund managers are also required to sell a part of the investment at opportune moment that the realized gains could be shown in the accounts for distribution of profits to which the investors of the foreign funds are rightfully entitled.

While it might be valid justification for such cases, and true that the foreign investors do hold the key to market fluctuations in a stock market like ours which is not only small but also lacks depth, this argument can in no way be employed to undermine the importance of the foreign investment. The fact must be kept in mind that this is about the only adverse impact the foreign investment can be described to have and that too is not an incurable ailment. With the development of the market, as would happen with the rise in the number of listed companies, maturity of the investors through education and experience and rise in the shares of the institutional investors, this negative impact of foreign investment would also become manageable. Besides, it betrays common sense to condemn one aspect of the flow of foreign investments at the expense of numerous positive developments that it brings to the domestic stock market. It gives a boost to investors� confidence in the equities and adds tremendously to the stock valuations despite the fact that foreign investors usually hold only 4-6 percent of the total market capitalization. As foreign investment mostly comes in the institutionalized form, it affects a healthy shift in the composition of a stock market like ours where the speculators are regularly accused of manipulation. Slowly, but surely, foreign investment helps the process of automation of the trading activities at the market and also serves the purpose of disseminating awareness and education among the local investors. But more importantly, it endows a certificate of credibility to the stock exchange activities and creates an atmosphere of trust among the traders.

Over the last decade or so, there has been a visible shift in the mood of our policy makers who are gradually coming to rely more on foreign investments rather than an aid or loans and a campaign has been launched and pursued by successive government to lure foreign investor in the domestic market. Without going into thee efficacy of this campaign or debating the means adopted to achieve the desired end, it needs be stressed here that we cannot find a better modus operandi for accumulating capital than foreign investment.

So far, investment worth more than $ 1.8 billion have come from abroad into our equity market since 1992.

An amount of $24 billion is reported to have been committed on the part of the foreign investors during the last 18 months. However, we do not expect the volume of actual foreign investment for the current year in Pakistan to exceed $1.6 billion by the end of the financial year. The share of portfolio investment out of this total expected foreign investment stands at $1 billion. Though, it may not sound like an extraordinary figure, given the prevalent conditions � both socio-economic and political � this amount is certainly an encouraging sign. But still, we cannot compare it with the level of investment flowing from abroad into other developing countries of the region. Thailand, for example receives foreign investment to the tune of $ 3 to 4 billion on average annually. Same is the figure for Indonesia while the Philippines inflow of foreign investment is estimated to be around $ 1 billion. India�s share is twice as large.

It is quite evident that our economy has just started to open up over the last decade or so and our stock exchanges are yet to attain their full potential. We can hope for a far more dynamic equity market once it matures, yet is would be foolhardy to anticipate any complement by deliberate and well formulated policies � not only in the sphere of economic activity but also in the realm of political and social restructuring. It must be kept in mind that a foreign investor does not just dump his capital in the market and stays out in his home town; his capital comes along with a whole paraphernalia which warrants some adjustment on the part of both the investor and the host�s environs. It goes without saying that security for his life and prosperity is a prerequisite. Furthermore, the problems of lack of an investor-friendly environment in our major urban centers should b addressed in a manner which neither hurts our value systems nor dissuades the investors from bringing in his capital. To state the truth, we do not have an enviable record as far as the law and order problems are concerned and there is a dire need for the government to take stringent and efficient measures to cope with this disturbing situation. The infrastructure that we have to offer to the investors form abroad should also be given a new look. Given the overall level of social and technological development of the society, it is quite understandable that the facilities present at our stock exchanges are quite below the international standard. The exchanges are quite of the stock exchanges should concentrate on improving the quality of our services so as to bring them at par with those of other exchanges operational in the region.

Conversely, some of the most attractive markets for the foreign investors are to be found in the South East Asia, especially Singapore, Malaysia, Thailand and Hong Kong. Three characteristics of these economies can easily be identified as the pull factors contributing to the growth in size of foreign investment in these markets, i.e. swift and smooth discharge of bureaucratic procedures, a tangible improvement in the civic facilities over the last two decades ranging from the use of state-of-art gadgets in market processes to modernization of traffic systems and last, but not the least, the quality of the social life in which an investor has to consume his leisure hours after a hectic business day. On these counts, in contrast, our country can hardly be considered as a competitive market. Unless we bring about major changes in our attitude regarding these issues, we cannot hope to lure foreign investors.

But probably the most crucial factor which would determine the fate of our foreign investment scenario is the continuity in government policies. Relationship between the two protagonists across the domestic political divide have been sour to the point of no return and political environment in the country is as hostile as ever. Nevertheless, fortunately, the economic policies of both the major parties are remarkably similar. Incentives given to the foreign investor in a number of sectors have persisted despite quick change of hands at the state reins. This factors alone can be considered as a propitious omen for a better future which is in store for our national economy and foreign investor is likely to show more faith in our market.
 

Researcher: Arif Habib

To discuss the Pakistan Stock Market we may refer to the data of Karachi Stock Exchange being the premier stock market of the country. Most of the companies listed on Lahore and Islamabad Stock Exchanges are also listed on Karachi Stock Exchange. The turnover of Karachi Stock Exchange is fairly contributed by these two fast growing regional Stock Exchanges whose members send the unexecuted orders at their exchange to the Karachi Stock Exchange Floor. This is an international phenomenon e.g. India has 22 Stock Exchanges but the Bombay Stock Exchange is regarded as the Indian Stock Exchange. Similar is the case of the New York Stock Exchange for USA and the Tokyo Stock Exchange for Japan.

The Karachi Stock Exchange came into existence in 1949. Initially only 5 companies were listed with a paid up capital of Rs 37 million. From this modest beginning the Karachi Stock Exchange today has become the key institution in the financial sector of Pakistan with 740 companies listed having a paid up capital of Rs 116.372 billion and market capitalization of Rs 339.480 billion which is equivalent to USD$ 11 billion. During its life of 45 years we have seen two wars, break up of one part of the country which is now Bangladesh, nationalization of banks and key industries, martial laws, Afghan war and precarious law and order conditions in Sindh particularly in Karachi. By the grace of God the market economic policies of the recent years. The free market economic policies of the recent government like d3eregulation, privatization and liberalization of foreign exchange controls have triggered the growth of Pakistan stock markets in the last four years. During this period we have also seen the qualitative improvements in the financial services available in our country. The following charts show the historical performance of the Pakistan Stock Market.

PERFORMANCE OF PAKISTAN STOCK MARKET PRE-1990


PERFORMANCE OF PAKISTAN STOCK MARKET POST � 1990

The stock exchange gained momentum during the 1960s when the number of listed companies went up from 81 to 291. this was due to encouragement given to industrialization by the then government in the form of tax holidays, subsides and export bonus incentives. This policy was aimed at converting an absolutely agrarian economy into a consolidated agro-industrial economy.

However, during early 70s, there was political turmoil in the country resulting in the dismemberment of the former East Pakistan into Bangladesh. Along with these government began a campaign of nationalization of companies and banks. This stunted the growth of the economy and the market. During 1980s, particularly in the second half we saw some policy changes like total exemption of dividend income in the hands of the individual shareholders, issue of Foreign Exchange Bearer Certificates to encourage remittances through regular banking channels and program to gradually permit the entry of the private sector in the financial system through Investment Banks, leasing companies etc. these measures restored the confidence of both entrepreneurs and the investing public to a great extent.

The year 1991 saw major changes in government policies. These included not only the continuation of the above policies but the opening of the market to foreign investors, privatization of public sector companies, deregularization of economy allowing commercial banks in the private sector and liberalization of foreign exchange controls. These policy measures are mainly responsible for the accelerated economic activities specially in the capital market. It is very heartening that the successive governments during the last four years not only continued these policies but pursued them very vigorously. These policies have now placed Pakistan in the category of new emerging markets of the worl with an outstanding foreign investment of US $ 1,5 billion in the companies listed on the Pakistan stock markets based on current market Euro Convertible Bonds and GDR markets. Dewan Saman Fibres Ltd. raised US $ 45 million in Euro Convertible Bonds market through issue of 7 year bonds with a coupon rate of 5% and conversion option at Rs. 195 per share. Similarly the international offering of PTC attracted an investment of US $ 890 milliom and substantial portion of subscription has been opted in GDRs by the international investors. This has been the largest issue of Pakistan and the second largest issue from the emerging markets after Mexican Telecom. Hubco and Chakwal Cement have also raised US $ 157 million and US $ 100 million respectively from the international market through the instrument of GDRs.

TABLE 6.1

Additionally a number of 100% equity financed companies like Lucky Cement, Dhan Fibres and Ibrahim Fibres raised altogether over US $ 130 million through pre IPO placement of their shares to international investors.

In tables (6.1 to 6.3), comparison is provided of the Karachi Stock market with other emerging markets particularly of the South Asian region which include India, Sri Lnka, Indonesia, Malaysia, and Thailand in respect of turnover, growth and return, figure 1 show the relative size of these emerging markets.

TABLE 6.2
TABLE 6.3

In the end, let us look at the present market conditions, the year 1994 has seen a 50% growth in its listed capital which has increased to Rs 104.137 billion from Rs. 69.476 billion in 1993. This large supply of securities has been one of the primary reasons behind the increased pressure on the prices of the listed shares. Political turmoil, social disorder, soaring inflation and rising global interest rates pushed Pakistani Equities sharply lower. Foreign investors avoided the market due to increasing tension between the Government and opposition, social disorder in Karachi and rising US interest rates. The Government�s ability to control the internal problems will determine the future direction of the market.
 

Researcher: Zaigham M. Rizvi

The players of global capital market, in the recent past, have identified a new market segment in third world developing economies (one may now call them �emerging economies�). The very fact that fund managers of the West, developed a �soft corner� for investment avenues in developing economies, has upgraded their status from �submerging markets� to �emerging markets.�

This market segment is further segmented into regional market:

i. Latin America:
Includes Brazil Argentina, Mexico etc.

ii. Europe :
Includes Greece, Russia and Turkey.

iii. Asia:
Includes China, India, Pakistan etc.

iv. South-East Asia:
Includes Hong Kong, Singapore, Taiwan,

v. Other :
Israel, South Africa

Three kinds of �finds� were floated for investment into these markets ;

1. Global Funds;
2. Regional Funds; and
3. Specific Country Funds.

The international fund managers, over a period of time, have geared their operation and expanded their outreach to meet the growing challenges of international fund management. The regional and country offices were opened in various regions and in specific countries. For Asian and South-East Asia region, regional offices were set up in countries like Hong Kong, Singapore and India, in addition to country offices in almost all important markets of the region. Table 7.1 show the size of various emerging markets on the globe. In Pakistan, nearly ten fund managers of international repute have opened their offices. There is a host of �Funds� which have been operating in Pakistan, making investments/disinvestments in equities.

In addition to investments out of specific country funds (like Pakistan Fund), these investible funds are available out of country allocation in global and regional funds.

The interaction of these funds had both good and bad impacts on the local capital markets. No arguments can be purely developed on the grounds that these investments are �disfunctional� and be avoided. One is bound to agree and endorse many of the positive effects, which these funds had on the Pakistan�s capital market. Naturally, these positive effects are some of those factors which have helped in qualifying these markets to �emerging� markets status. The problem only starts when the �Wise Monkey� while referring to positive side of foreign private investment on emerging markets, would SEE-everything, SAY-everything and HEAR-everything. On the other hand, when the same �Wise Monkey �while referring to negative side of the picture, prefers to SEE-nothing, SAY-nothing and HEAR-nothing. We all know, that by way of gossips, some people casually express apprehensions of East India Company�s style operations when they see the emerging and powerful muscle of foreign fund managers. The actual stake of �foreign funds� in the Pakistan�s market, excluding PTC & HUBCO, could be as little as 4-6% of total market capitalization. The figure enhances to 13-14% inclusive of mega issues of PTC & HUBCO. The situation gets more alarming when we move from capitalization to turnover statistics. The trading in PTC & HUBCO account nearly two-third of total trading volume, giving a very clear edge to foreign fund managers. This is that �strong manipulating role� of foreign funds which is a source of concern, and should be addressed at such forums discussing the behavior of Pakistan�s capital market.

DENATIONALIZATION AND RENATIONALIZATION

The article simply ventures to present some �food for thought� to our economic planners as well as to professionals in financial circles. No single person can claim any credit for being so thoughtful, since such apprehensions are casually being expressed by many activists and market players. We have seen the slogan of privatization, emerging on global scene, in late eighties and early nineties. The third world economies were obsessed by the calls for de-nationalization and privatization, in the same vigor they had seen zeal for nationalization and state controls. The privatization process has two aspects :

(A) DENATIONALIZATION OF NATIONALIZED ASSETS

Privatization of earlier nationalized assets like banks and manufacturing enterprises.

(B) PRIVATIZATION OF NATIONAL ASSETS

Privatization of national assets, in the sectors of communication (PTC, PIA, Railways), minerals and petroleum (OGDC) and Power (WAPDA).

While �denationalization� of assets, which were nationalized by earlier regimes, could be of routines nature the privatization of national assets under category (b) is a major concern and is likely to agitate our socio-economic structure. The answer is very simple. The fact remains that our market does not have enough liquidity to absorb such stock-market based privatization. Naturally, the need arises to import liquidity (i.e. attract foreign funds) into local market. Since funds for investments in major issues like PTC are largely foreign based, the control of such assets moved from national to international forces. One may term this process as �re-nationalization� of assets i.e, change of their nationality from local to foreign based. In order to attract foreign capital there arose a need for shifting the economy form over-regulation to soft-regulation and finally to total deregulation. To make the environment more conducive for foreign capital, the exchange controls had to be relaxed and finally to be removed. The foreign fund managers, who are primarily responsible to prudently invest their funds to avenues where economic returns are safer and better, had plently of choices between competing emerging markets.

GROWING COMPETITION FOR EXTERNAL CAPITAL AMONG EMERGING MARKETS

The world is seeing a growing competition for private capital among emerging capital markets. Accordingly to a World Bank report, of the $ 225 billion that flowed into all developing countries during 1994, three quarters or $ 170 billion, was private capital � mostly invested in securities, and only $ 55.0 billion was official assistance. As recently as 1989 the total was just $ 80 billion of which about half was private flow of capital.

The foreign funds manager�s interest in a market depends upon the following factors ;

1. external capital is linked to the currency stability and that in turn is linked to economic stability and financial discipline in a country;
2. the knowledge of the market, the economy and surety of regular and timely information flows; and
3. comparatively better yields.

The foreign funds, compared to local funds, are generally better placed in view of the following:

1. They have the capacity to play in a big way;
2. They can take losses and thus can afford rapid with drawls;
3. They have superior organization for fund management ; and
4. Their knowledge of the market is relatively better which they have gained over a period of time.

Since the foreign funds have a stronger muscle, the capacity to quickly enter or exit , the first knowledge of their plans for a particular market is going to be an emerging or submerging market at a point in time.

MEXICO TRAILER

The world�s securities markets appear once again to have become the play-thing of �technical factors.� Last year it was the activities of the hedge funds that caused this result; this year just as it seemed that �fundamental � influences were regaining the upper hand, another burst of �technically � inspired �selling has begun. In 1994, it was the over-exposed bond portfolios of the hedger that caused the problem; in 1995 it looks as if it might be the equally over-extended Mexican position of a bunch of US investors that risks similarly upsetting the applecard.

We are not MEXICO! Cried the world�s emerging markets. It was all in vain. Around the globe � in Europe, in Asia, in Latin America � the emerging markets suddenly became submerging markets were apparently being punished for the sins of Mexico�s economic planners. In Hong Kong, where the impact of Mexico fiasco was severe, the portfolio managers mentally rechecked their maps. Where the Mexico is, anyway? One of the Hong Kong based treasurer shouted: �The whole thing is non-sense. How can you compare Hong Kong with Mexico.�

At some other quarters in Europe and America, some different questions are being asked- Had the global economy become a free for all, with no one incharge? In short, was Mexico�s triggered worldwide ripples a maddening over-reaction � or was it a salubrious warning to countries that were failing to manage their economies adeptly? Actually it was both. Mexico�s crush had a dominos effect on all emerging markets, resulting in a wave of emerging and submerging markets. Take heed, you could be the next.

While some blame Mexico for hiding its worsening economic conditions and failing PESO, others blame World Bank and IMF for not being able to assess the worsening conditions there and disseminate this information for the benefit of global investors. The reason the market-place was bind �sided in Mexico has everything to do with an absence of information about day to day and week to week short term changes in Mexico�s current account and reserve levels. �Mexico, as most agree, deserved much of its fate because it had become totally addicted to short term inflows of stock market investors� was widely expressed opinion . Can we, the third world economies, afford to agree with that attitude of global investors, while looking at our covert and overt financial indisciplines.

An article in Newsweek (Jan 23, 2025) reported � �The new rules of global finance became suitably clear after Mexico�s crisis. Rectitude will be rewarded. Any country with a week Government (Spain, Italy) a large budget deficit (Sweden, Canada) or less than credible economic policy (Mexico, Philippines) will have an uphill battle to draw money. Investors may become more discriminating and assertive. Mexico�s currency crisis and its aftermath has costed it $ 40 Billion by way of rescue package from USA. The American reaction was quick, but only after surfacing of the economic crisis which anyway, was potentially there since long. The foreign capital, while being reinvested in Mexico through rescue package, was getting fortunes it could never imagine. This was not a beginning of an end, it was in fact beginning of a new era. The private capital is developing much stronger links with the fate of emerging and/or submerging markets. As a high ranking aide to Mexican President puts it, �Now we know that it�s the small US investor who calls the shots.�



EMERGING MARKETS LIFE CYCLE

More Faber, the Managing Director of March Faber Ltd, USA in an article �Understanding Emerging Markets Life Cycles� illustrates the 6-phases life cycle of emerging markets starting with submerging status and existing into the same status. Pakistan�s market is probably in Phase-I or Phase-II. A global investor can always be, by choice, in an emerging market and make fortunes while the local investors of a submerged market will be exposed to difficult decision.

THE NEW HORIZON

What becomes clear after the Mexican crisis is that the ability of the IMF, the World Bank and the Group of 7 nations to address a major financial crisis has been dwarfed by the sheer power of private capital. During the periods of dominating role of official assistance, the World Bank, the IMF and the Asian Bank had a minor role to play in shaping economic policies of the developing economies. Conditionalties were the rule of the game. You have to agree if you want the official assistance. Beggars are never the choosers. At least, the beggars of that era had the option of declining whether to beg or not. They could work for self-reliance. The modus-operandi and operational strategy of these multilateral agencies was modest, sober and gradual. This gave economic planners some cushion in terms of time to bargain on conditionalities. With the gradual shift of foreign investment from official to private flow of capital, the rules of the game are changing in favor of �Portfolio Managers.�

Strategic moves to this effect are already on the scene. Role of IMF and the World Bank is being taken up by �Investors Group�, the Fund Managers. Marc Uzan, a French economist who formed the Re-Inventing Bretton-Woods Committee, is recruiting financiers and investors for a �World Investors Group� that would represent the new power of portfolio managers. It will be the first formal form between governments and �markets� encompassing managers of pension and mutual funds, insurance companies and the representatives of the IMF, the World Bank, the development banks and similar agencies. Some small and adhoc groups already exist. There is a shadow G-7 group of 14 fund managers that meets twice a year. A �20-20� group, consisting of 20 fund managers and 20 giant US Corporations is also functional. Such formalized forums could implicitly impose conditions on the governments � now that emerging markets respect the power of private capital to withdraw en masse. They would modestly propose conditionalities, else brutally impose them through market pressures. Mexico had no choice, and no country would, once it is trapped in the foreign capital. How many emerging markets arE egeared to face the emerging challenges tot heir economic sovereignty.

PROTECT YOUR ECONOMY FROM �CRIMINAL MONEY�

Hundred of billions of dollars of criminal profits fins their way into the open market every year, after being �laundered� by international crime syndicates. The money mostly earned from drug trafficking, threatens to undermine legitimate business, particularly in the world�s, developing financial markets. �It strengthens the economic power of criminals and gives them the power to corrupt political systems� said Dilwyn Griffith, Director of the Finial Action Task Force (FATF), which monitors international money laundering. This possible control of capital markets by �criminal money� may lead to their political control by Money Laundered. �No one knows, how much money is being laundered .� A plausible figure is $ 300 billion a years � presumably it goes on to virtually every country in the World. A country�s need for capital may perhaps lead it to take short-sighted view that money has no smell, that it does not matter what the origin of the money is�.

�You cannot open your economy without taking measures to protect it from criminal money, �(Adopted from an article �Money Laundering is Global Threat by Dominic Evans, published in Financial Post May 10, 1995�)
 

Salman S. Ali

Economics is a social science that constitute an integral part of the ideology which prevails in a certain society. Thus, there is no Islamic �Economics� per se unless there is am Islamic Ideology prevailing and applied in the total life and activities of a Muslim community. Stock market being an important institution of the financial sector of the economy is also subject to the same criteria.

The importance of stock market and its rapid emergence in Pakistan as well as other Muslim thinkers and scholars and involvement of the masses to make deep examination of this institution, reject what is found repugnant to Islam and legitimize that could be accommodated. Unfortunately there is no state-wide example where economy is managed according to Islam injunctions. The Muslim scholars and economists are therefore only clarifying the theory and soliciting through their writings and speeches commitment of the masses and the government for an Islamic alternative.

What, therefore, is presented here is a review of the opinions offered by eminent scholars and specialists, which still awaits to be tested within a total Islamic framework.

The paper is organized as follows. Section one will discuss the role of stock market in economic development as recognized by Islamic economists. Section two will discuss permissibility of various assets and contracts that are traded on the contemporary stock market. Section three will address the issue of speculation in the stock market followed by concluding remarks. A bibliography is also provided at the end to facilitate the interest reader to explore more on the subject.

1. ROLE OF STOCK MARKET IN ECONOMISED BY MUSLIM ECONOMISTS:

Economic development and the development of financial markets a re closely related to each other to the extent that a cause and effect relationship is considered to exist the development of financial sector causing growth in the real sector. The importance of the financial markets cannot be marginalized and various turning points in the history testify to its significance. The commercial revolution that started in Europe in the tenth and eleventh century was essentially about innovation and adoption of new financial techniques and development of new commercial practices that resulted in expansion of trade gradually over the centuries. It was the first step, silent and slow though, that resulted in the rise of the West.

In that period various institutions such as the trade fairs, and guild merchant organization came into being to meet the needs of trade and commerce.

Evident from Muslim history also suggests similar pattern. The contracts such as mudarbah and musharika were not by �prescription,� but were modifications of the existing contracts that the Prophet (salallah-o-alaihiwasallum) approved or did not prohibit.

These same contracts were later passed on to Europe through Italian and Jewish merchants trading in the Mediterranean region. The contractual form known as �commenda� in the medieval Europe was actually derived from mudarbah contract. This suggest that the development of contractual forms and financial techniques are constantly in flux and follow an evolution process within the boundaries of the norms and values of a society. This development is geared towards solving particular requirements of the economy relating to provision of liquidity, flexibility in transactions and ease in application.

When we look at the stock market, which is a vital arm of the contemporary financial system, we must not confine attention to a few contracts termed �Islamic � and ignore the possibility of coming up with new contractual forms that are compatible with the principles of Shari�ah. At the same time we will have to bring to contracts that violate the rules of Shari�ah. Thus a right question to ask is: what are the requirements of the economy in our period and how those requirements can be met through the existing or by development of new contractual forms that are in line with the principles of Sharia. This is exactly the question asked explicitly by El Gari in his 1993 paper and by many other Muslim scholars implicitly in their analyses.

The first thing to note in the literature dealing with stock market form Islamic point of view is that no author has negated the usefulness of this institution. Rather they have appreciated its existence, and demonstrated a good understanding of the functions and objectives of the stock market which are:

1. To attract savings and channel them for investment.
2. Match the preferences of the savers and investors pertaining to liquidity, risk and return by designing appropriate contractual forms that can finance a long term project through a series of short term financing contracts.
3. Make available tools to price the investment risk.
4. Provide a yardstick to evaluate tools to price the investment risk.

These objectives are served by taking a number of measures : (i) span the possibility of risk and return positions, (ii) increase the contract enforceability, (iii) reduce the contract negotiation costs, and (iv) increase the chances of matching the buyers and the sellers. Few such measures are :

a. Standardization of contractual forms. This has direct bearing on lowering the negotiation cost, and the ease in analysis of risk and return aspect of an asset.
b. Recording and registration of each contract. This helps in enforceability.
c. Existence of a central clearing house. This can help in matching of buyers and sellers.
The second thing to note in this literature is discussion on permissible forms of securities � financial contracts. This is the topic of the next section.

2. VIEWS ON PERMISSIBILITY OF VARIOUS CONTRACTS

The asset claims traded on the present day stock market include, (i) various types of bonds, (ii) shares of stocks, (iii) options, (iv) warrants, (v) future, (vi) forward contracts and, (vii) other derivative securities.

TRADE IN BONDS

There is an agreement on non-permissibility of bonds because they are claims of interest.

TRADE IN SHARES

As far as the sale and purchase of shares is concerned Muslim Scholars permitted its trade both in the primary as well as in the secondary markets. The understanding is that buying a share of a company is establishing ownership in the assets of the firm in proportion to that share. Views on permissibility and conditions are briefly outlined below :

We refer here to Mualana Taqi Usmani (1994) who gave his opinion that shares signify ownership in a company�s assets to the extent and value of the shares held. It is thus joining entrepreneurship like Qirad or Mudaraba and is permissible. In the case of initial floatation, a person buys share(s), yet in fact, from Sharia viewpoint, he purchase nothing material but only a certificate of ownership in the company�s assets in proportion to the number of shares held. If the business of the company is not forbidden, the deal is permissible.

After the initial stage, the resale of such shares only means changing hands of the ownership. For such an exchange, Shariah impose certain conditions :

(i) As noted above, the business of the company should be halal.
(ii) The company�s asset should not be wholly liquid; it must have acquired fixed assets too, otherwise the sale of shares above par or below par will not be permissible, because this will make the case of riba-al-fadhl, like exchange wheat for wheat, gold for gold and money for money with a differential price.
(iii) In a situation where the assets are both in liquid and fixed forms, the minimum price cannot be below the proportionate value of liquid assets.
(iv) If a company is �provisionally listed,� its shares cannot be purchased or sold above or below the face value (value at par). Because this company, by definition, is in the process of mobilizing funds and no part of that is yet physically invested.

In essence these measures define an endogenous lower limit for the share price of each firm that depends upon its assets structure. It is therefore, essential that each firm announce its balance sheet regularly and correctly.

An advantage of this method of asset pricing is that the asset prices are more linked with the actual economic activity.

OPTIONS

Purchase of a �call option� is purchase of a right to buy a commodity or services in future at a price that is agreed upon today. This right will be exercised by the purchaser when doing so is beneficial. This happens when in the arrival of that exercise period the price in the spot market is higher than the price agreed upon in the call contract.

Purchase of a �put option� is purchase of a right, on payment of a fee today, to sell a commodity or services in (some) future (date) at a price that is agreed upon today. This purchased right will be exercised when the spot price of the commodity or services is lower than the exercise price.

Majority of writers in the area of Islamic economics are of the opinion that �options� are not permissible in Islam. El-Gari differs from this in that he justifies call options on th basis of permissibility of bai al-arboon by the followers of Imam Hanmbal�s school of fiqh. Bai al-baroon is a sale agreement in which a security deposit is given in advance as a partial payment towards the price of the commodity purchased. This deposit is fortified if the buyer failed to meet his obligation. El-Gari�s opinion is based on making analogy between two non-anologous contracts, that is , the al-arboon sale contracts and the call option. In al-arboon the advance payment is made towards the price of the commodity purchased. The partial payment in advance obliges the seller to reserve the commodity for this buyer and not to sell it to another person unless the buyer refuses to buy it by refusing the remaining payment. Whereas in the case of call option (i) the price paid is the price for the option to buy a commodity and not the partial payment towards the price of the commodity, (ii) often the commodity itself on which the options are sold and purchased is not possessed by the seller and sometimes the commodity may not exist, (iii) the option itself can be re-traded to any buyer for a price. So the two contracts are not equivalent.

El-Gari also rationalizes permissibility of the put option by arguing that it is a fee for the service by the buyer of put option to sell the commodity in future at an agreed upon price. All other writers on Islamic economics do not consider options a legitimate instrument.

FORWARDED CONTRACTS

Role of forward contracts is more important and justifiable in commodity exchange than in the stock exchange to facilitate dealings in varied circumstances. Khan states that �from the Islamic point of view there is hardly anything objectionable in the basic operation of the forward market. Individual transactions may have certain elements which need to be modified in the light of Islamic law�.

FUTURES

According to Khan , the trade in futures is not permissible in Islam because the commodity that is traded is non-existant, �it does not involve physical transfer of commodities and successive sales are made without anyone actually owning the commodity.�

3. SPECULATION

An important aspect of the contemporary stock market is the existence of high degree of speculative trade.

As a result the stock prices fluctuate too much to be justified by changes in the economic fundamentals. The stock price then becomes un-informative for the valuation of investment opportunities and in chanelling of funds for the efficient allocation. Confirming to this there are many studies. One can look into the study by Balnchard. Rhee, and Summers (1993) who found limited role for market valuation when managers take investment decisions. In addition to the empirical findings there are also theoretical arguments on how speculation is price destabilizating and welfare reducing activity.

Recognizing the possibility of speculation, all authors, who are surveyed here, advocate a sane stock market where prices should not suffer from undue volatility and gyration.

Chapra (1985) identified forward purchase or sale of stock on margin as the source of unhealthy movements in stock prices. Because most of these deals are made without the intention of taking or making the actual delivery . According to him �Margin purchases and sales bring about an unnecessary expansion or contraction in the volume of transactions and, hence, in stock prices, without any real change in the economic conditions. �

For sale of shares before effective delivery the principle is that nothing can be sold without not only �physical possession� but also �constructive possession�. When something in under one�s own �risk�, only then it can be sold ahead. For this purpose the effective exchange of risk is considered enough, although a more careful approach will be to await physical delivery and receipt of the share certificate.

If shares are purchased only for capital gain then the whole amount of shares will be subject to zakat deduction. Otherwise zakat is deductible only on liquid assets which means excluding buildings and machinery.

El-Gari (1993, p.9) also recognizes the possibility of speculative activity to the extent of gambling �because the forms and modes of the contracts do not reveal the real intentions and aims� of the investor. He proposed three regulations (i) use of tax system. For example, taxing at higher rate, the capital gain obtained by selling the share quickly after the purchase, and taxing it at a lower rate if the same share is held for longer period. (ii) Placing a limit on the share purchase by institutional investors. (iii) Putting restriction on price changes within a day.

Metwally (1984) is also very much concerned about how to distinguish price changes resulting from changes in performance of a firm and those resulting from the changes in the psychology of the market. In order to reduce the excess violatility in asset prices and tie them more closely to the real economic activity he proposes formation of a regulatory body � Management Committee of the stock exchange that should determine the price ceiling for each stock based on the company�s average net worth. He also recommends specified trading periods for trade in shares so as to reduce the frequency of trading.

But this proposal goes against the liquidity aspect of the stock market. The fixation of the price ceiling is itself difficult job that requires too much information process that is not readily available.
 

Market Summary