The proposed KSE rescue: both initiatives ill-thought out and manifestly irresponsible

The Ministry of Finance has just announced its blueprint to rescue Karachi Stock Exchange which has been in suspended animation ever since last Augusts' ill-advised SECP/KSE decision to put a floor of 9,144 under the KSE-100 Index. According to Financial Advisor to PM, Shaukat Tarin, The PKR 50 billion (approx USD 580 million) proposed initiative will be commercially funded with GOP guarantee as backstop.
It has two components. A funded portion of PKR 20 billion (approx USD 230 million) is proposed as a Market Stabilisation Fund to be managed by NIT. It will reportedly invest only in 7 leading Companies majority-owned by GOP (OGDC, PPL, SSGC, SNGPL, KAPCO, PSO, and NBP) that together have a 30% weightage in KSE-100 Index.
The non-funded component will be by way of 12 months "Put Options" favouring foreign investors as inducement to forestall their market exit on October 27th when the abovementioned floor is removed. This latter initiative is obviously a desperate attempt to avert an undesirable impact on the country's already dangerously depleted FX reserves. Your scribe deems both initiatives ill-thought out and manifestly irresponsible. Let's see why.
First, any commitment of public funds in a Presidential system needs legislative approval. The recent massive USD 700 billion market intervention in America was first hotly debated and rejected by Congress. Only after a concerted bipartisan effort was the bill passed on its second reading. Then and only then did the American Treasury begin its market stabilisation efforts.
In a Parliamentary system though, I am informed that pre-fact legislative approval is not necessary. However, expenditure of this magnitude is definitely debated, as was the case in Britain when Gordon Brown outlined his financial rescue package.
The proposed initiative that commits PKR 50 billion worth of tax-payers money certainly deserves serious debate in the National Assembly! Secondly, The PKR 20 billion cash fund is patently biased and inadequate. With KSE-100 depleted capitalisation still around PKR 2.75 trillion, the proposed investment is worth less than one percent of total market capitalisation.
In fact, it is a miniscule fraction of traded market capitalisation of the seven target companies. Such a feeble attempt will clearly enhance rather than diminish market anxiety and reinforce the anticipated mad rush for exits on October 27.
Net, net, GOP may end up with loads of "Treasury Stock" in its own companies to reimburse rich private mutual funds, brokerage houses, and banks that had gambled and lost! Obviously, the small investor who GOP should be protecting does not hold PKR 20 billion worth of targeted companies' stock.
What of the non-Government public companies in which the common man holds a bulk of his investment? In short, if this program is implemented, in any post-event Parliamentary debate, the Government will be seen as partisan, foolish and foolhardy.
Thirdly, the concept of offering "Put Options" to foreign investors raises many eyebrows. To begin with, it demonstrates SECP's ignorance and naivete about pricing of derivatives. The foundation on which Option prices rest is market Volatility. With the floor in place, recent market volatility has been practically Zero.
How will any Option Trader (do we have any in Pakistan?) determine a Put-price? What Sigma (as the jargon goes) will he use to price the 12-month Puts in favour of foreign investors? I suppose our geniuses at SECP haven't thought that far ahead. Fourthly, the proposed Put Options in favor of foreign investors will be immediately challenged in court as providing them an unfair preference vis a vis local investors.
Fifthly, if SECP "Writes" these options, even conceding that it has the legislative authority to do so which it obviously does not, it will perforce use a Sigma (Daily Volatility factor) of perhaps 5% (if not more) which was prevalent in August just prior to implementation of the Floor under the KSE-100 Index. That translates into an annualised volatility of 78% based on a 242-days trading year.
To save SECP the bother, your scribe has just done the needful in 10 seconds on his hand-held HP calculator using Black-Sholes model. It shows that for a Stock currently priced at PKR 100, 12 months Put Option would be priced at PKR 22! Which foreign investor will pay that kind of premium to buy the Put Option? He'd much sooner sell the scrip outright.
And if SECP intends to offer these Options free of cost to foreign investors, the unpaid Option Premium will be the effective opportunity cost borne by our tax payers! To my mind it is inconceivable that a savvy professional like Shaukat Tarin could have given his blessings to such a scheme. It is most likely a product of SECP's management expertise! If so, let them first sell this hare-brained witches brew to Parliament and watch the fireworks!
For those of my admittedly miniscule readership that may have missed my article that appeared in these columns on October 21 (titled "Capitalism Comes a Cropper!"), I had anticipated some form of Governmental initiative at containing the fires raging at KSE. In it, I had suggested two common-sense approaches at rescue. Perhaps, these need reiteration. Briefly, the market support I had endorsed was as follows:
-- Let the Government's market stabilisation fund be first used to provide safe exit to small investors at the going prices...ie Floor-constrained prices of all scrips as they exist today.
-- Then remove the Floor and let prices settle where they will. For brokers that wish to off-load their portfolios, the "Stabilisation Fund" should be used to buy whatever equities the distressed brokerages wish to sell "At the Market". If some of them go belly-up in the process, let them. Sell their seats to recoup losses. Any excess losses should then be borne by the Exchange and its Insurance for trading losses.
For brokerages that are not insolvent, only illiquid, the "Stabilisation Fund" should be used to provide them liquidity at adequate lending margins (ie against security of blue chip scrips with 40-50% lending margins) and at the going rate of interest.
Additionally, if they so desire, the "Stabilisation Fund" could write "At the Money" 1-3 months "Put Options " for them that would not be near as expensive as the one-year Puts mooted above (if for nothing then the simple logic that as markets settle down, volatility will revert to lower norms).
The related Option Premiums would be handy income to the "Fund". For foreign investors that have USD 2 billion reportedly at stake at KSE, your scribe had suggested that they be allowed to exit at will. Any engineered delay or deferment in this process will do untold damage to the future of our Capital Markets.
Of course, the Government can seek their co-operation to the extent of providing them instead high-yielding USD bonds of tenors that bridge the Government's current liquidity bind. If that is done, most foreign investors would surely appreciate the underlying GOP good intent and will likely cooperate with it.
Finally, a word about the Government's Market Stabilisation Fund. Common sense dictates that its magnitude should be proportional to total traded market capitalisation. I had indicated that for a market capitalisation of PKR 2.75 trillion, any initiative less than PKR 100 billion will be meaningless.
Perhaps, even this estimate is too niggardly, and an amount twice or three times is more appropriate. But, in any case, this needs to be debated in Parliament. The ball is really in the court of our National Assembly.
It is too early for SECP to declare "Game, Set, and Match". I suspect we are in the eye of the storm, and have yet to face gale-force winds on the hurricane's periphery. May God give KSE, SECP, and the Government courage to change what they can, the forbearance to accept what they cannot change, and the wisdom to know the difference.([email protected])