With the Pakistan stock market rebounding over the last several weeks there is a sense of euphoria amongst market participants. And rightly so, as the long doldrums in the market appears to be over and improved macroeconomic fundamentals get factored into stock market valuations, along with expectations that interest rates may have peaked - which is always a positive for stocks. However, this breathing space provided by short-term positive market movement should not lead to complacency on structural reforms urgently required in the capital market. Indeed, this is a good time to reflect on the core challenges facing the market and market participants which have been inhibiting the development of the capital market as a key source of long-term capital for industry and commerce.
Thanks to the Asian Development Bank's (ADB's) initiative well over a decade ago, Pakistan's capital market witnessed major reforms with institutionalisation of the Securities and Exchange Commission of Pakistan (SECP) as the apex capital market regulator. The ADB initiative also strengthened and deepened the management and skill capability of the SECP. This has led to a robust regulatory regime and significantly reduced previous governance weaknesses in the securities and asset management industries, while strengthening risk management capacity and investor safeguards. Positive steps were also taken to improve the organisational and technical capacity of capital market infrastructure institutions: the stock exchanges, the clearing company and the electronic central depository company. All of these reforms eventually led to the demutualisation and amalgamation of the three exchanges in the country (ISE, KSE and LSE) into a single stock exchange - the Pakistan Stock Exchange (PSX).
As a final bifurcation of interest between brokers and exchange owners, 40% equity ownership of PSX was sold in May 2017 to a consortium of Chinese exchanges and investor partners (China Financial Futures Exchange, Shanghai Stock Exchange, Shenzhen Stock Exchange, Pak-China Investment Company and Habib Bank Limited). As per SECP regulations, seven out of 14 board members now comprise of independent directors in order to ensure good corporate governance and diverse insights to develop PSX into a modern securities exchange comparable to regional peers.
This is quite an achievement. However, much remains to be done. While the first ADB initiative focused primarily on the regulatory and infrastructure landscape, the need now is to proceed towards a holistic upgradation of the entire capital market eco-system, including its efficiency as well governance aspects. This also means addressing the raison d'etre of the capital market itself. Assuming we agree that the primary function of the capital market is to source long-term risk capital for the development of business and industry as well as for public sector entities for infrastructure development (in the sense of public-private partnership), it is clear that the capital market has to be well-functioning with sufficient base of relevant securities issuers as well as interested eligible investors, along with strong intermediaries (asset managers and brokers). Without a large and diverse base of these three elements, the capital market will not be able to play its due role in economic development of the country no matter how strong the regulations.
In this context, critical areas that policymakers should focus upon include:
Increasing investor confidence: The total base of investors during the last 10-12 years has oscillated between 225,000 to 250,000 despite continual awareness generation campaigns by the SECP and PSX in collaboration with asset management and securities industries. Due to past deficiencies and several high-profile failures, the reputation of the brokerage industry has been severely hurt. While much progress has been made to rectify the situation with a more stringent regulatory regime and stricter enforcement actions, historical memories are strong and perception of the securities market as a speculative arena rather than an investment venue is now widely entrenched in the public mind.
Given this dynamic, what is needed is a government initiative that provides a broad safety feature to investors in the capital market just as the banking sector has a deposit protection scheme. In this context, a sizeable investor protection fund should be established with an initial capital of PKR 25 billion and administered independently by trustees and professional management. The initial funding of this fund can be a combination of long-term concessionary finance and grant by, for example, the ADB and government budget allocation. Over the medium-term (such as after five years), a tariff on stock trading can be used to generate additional funding. Of course, there will need to be specific conditions under which this fund can be used, and these details would have to be clearly formulated and put in regulatory/legislative format. The template for the workings of such a fund already exists that deals with the current investor protection regime administered by the National Clearing Company of Pakistan (NCCPL).
Attracting securities issuers: As noted earlier, the primary objective of the capital market is to support economic development by encouraging companies to obtain longer term growth capital via listing their equity and debt on the stock exchange. Within a broader positive macroeconomic context, listing on the stock exchange has several well-known advantages for specific companies, including:
- Non-collateralised long-term capital raising
- Obtaining a market-based valuation of share price
- Assisting with balance-sheet and corporate restructuring
- Potential for enhancing debt-assuming capacity of the company
- Creating the 'currency' for future acquisitions using shares of the company
- Enabling easier distribution of sponsors' wealth to the next generation
- Exit route for private equity investors
- Potentially higher collateral value of the company's shares
- Improved corporate governance and transparency leading to greater Brand equity
- Better image with suppliers, customers, business partners via greater media exposure
- Performance-driven compensation to management/employees through share options
- Share price and trading analytics service for listed companies
At the same time, listing also imposes greater responsibilities/risk on listed companies:
- Higher public disclosure regarding the company's financial condition and operations
- Greater regulatory scrutiny and accountability
- Cost of listing and ongoing compliance - both financial and management time &effort
- Poor financial performance may lead to under-valuation of the share price
- Potential danger of share-cornering by speculators/uninvited acquirers
On the whole, however, listing helps document an important and productive section of the economy, which is the need of the hour.
There are many ways of explaining to company sponsors that potential benefits can outweigh possible costs/risks of listing. These require a well-designed and consistent marketing effort by the exchange in partnership with securities firms/investment banks. The key is consistency. It has to be an ongoing effort and specific resource allocation needs to be made towards this end. The single biggest incentive for sponsors of private companies for listing on the stock exchange is to demonstrate to them how share-price performance enhances the enterprise value and wealth/net-worth of sponsor shareholders' over time. To be sure, there is a link between market performance and demand for listing by private companies. A rising market capitalization (good performance of the market) over time, has a positive relationship with sponsors' wealth increase through listing. Now is the time for policy makers and the Exchange to make it easier for companies to list.
In an economy with 220 million people where the effective GDP (official plus undocumented) is estimated between US$350 billion to UD$400 billion and with real GDP growth averaging around 4% p.a. historically, longer-term domestic business opportunities are not lacking, despite the current macroeconomic adjustment doldrums. What is needed is (i) reducing impediments to the stock listing process both in terms of over-regulation and technology-driven efficiencies; (ii) changing the current perspective about the stock market through branding, marketing and partnerships; and (iii) seriously implementing the SECP-approved (Small & Medium Enterprises) SMEs Exchange platform in close coordination between SECP, PSX, the banking industry and market participants.
(To be continued)
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