Falling markets

Market regulators are now involved in fire fighting to protect the economy from a sudden melt-down. The Sate Bank of Pakistan has taken administrative action to reverse the steep fall of Pak rupee. The Securities and Exchange Commission of Pakistan, had last month put in place a lock mechanism with the objective of a more orderly retreat in the market with a view to providing a necessary cooling period essential for the market to recover from the state of affair at that time.
Unfortunately, the erosion of rupee value against US dollar by 6.6 percent in one week as well as the fall in securities below their intrinsic value has more to do with the chaotic political conditions and less to do with the economic fundamentals.
The worsening trend in macroeconomic indicators has been there over a year. So is the rise in inflation. Despite reduction in the level of subsidies and upward adjustment in energy prices, market forces are not convinced that the direction of the economy is towards the right path.
SBP started its monetary tightening in July 2007. It was expecting to see its positive impact, but this did not happen primarily because of inaction of fiscal managers who did not want to upset the election plans of the ruling clique. As a result of February 18 elections, however, a broad-based coalition came into power. It was hoped that the country would now move towards political stability. That has not happened and the political fever is not subsiding.
It is not 'mis-governance' but a general perception of 'no-governance' which has led to the negative sentiment among investors. The pace of currency weakening and deterioration of economic fundamentals do not have a correlation. Similarly, the dislocation of real and perceived value of scrips is not in line with the future profitability of the companies.
Discontinuation of forward cover on imports and meeting payment for oil imports from forex reserves have enabled SBP to control the liquidity on the interbank forex market, and thereby to influence the rupee-dollar parity. Similarly, SECP is attempting to create an Equity Market Opportunity Fund with the objective of providing stability and liquidity to the market.
The objective is laudable. However, the proposal appears to be a non-starter. Other countries in similar situations had created identical funds. However, success in most cases was limited.
Further, the fall of KSE compared to other bourses in the region is not so sharp. Then, why should public institutions bail out market participants? All SECP needed to do was to provide a policy guideline as bullet points to help Karachi Stock Exchange develop a plan to get out of a perceived crisis.
The guideline needs to be based on market requirements and not on proposals emanating from market participants themselves. Equities are meant to give long term returns. In principle, the longer one holds the scrip the higher is the return. Investors know that there are gains as well as losses in business. Stock markets are not deposit takers.
Without a depository insurance, even bank deposits are not fully protected. All a Central Bank does is to provide liquidity in case of a run on an institution. This is essential as the interbank borrowing of a falling institution impacts other banks and this can cause a systemic risk.
Therefore SECP must allow financial institutions and mutual funds to enter the market of their free will when they feel valuations are attractive and the depression has finally begun to show signs of bottoming out. Fears that outflow of $3.5 billion invested by foreign funds in the bourses could cause a strain on the depleting forex reserves, are genuine.
However, making exit more difficult (by reducing the lock to 1 percent) has not helped but has only heightened the danger. The SECP decision to restore the locks at 5 percent from Monday (July 14, 2008) and not to wait till mid-July is a right step. Foreign fund managers cannot forget the 1998 forex freeze. SECP needs to reconsider its decision and allow the index to come to its natural level.
If 20 scrips in the KSE-30 index go down, 10 will also go up. The KSE Board must take steps which reduce the cost of doing business such as client level netting and cash margins, while maintaining adequate risk measures to cover settlements. Investment in KSE and real estate are quite inter-connected. As such, losses on bourses will bring the real estate prices down.
This would not be such a bad thing. Foreign investment, whether for portfolio or as direct investment or even the money sent abroad by Pakistanis, will only come back with political stability and consistent improvement in macroeconomic indicators. The regulators cannot battle with one hand tied behind their back. Political leadership needs to step forward and take charge.