Real capital formation is very low in Pakistan. Outside the equity market, which is largely dominated by a few companies, there is little scope. What do you think can be done to turn this dynamic around? When we talk about capital markets, there are three key markets - stock market, bond market and money market.
As far as stock market is concerned, first we need to have standardized leverage products developed through a consensus between the stakeholders. The basic features of a good leverage product should include proper documentation, transparency, price discovery and uniformity.
But didn't CFS have these ingredients? Yes, CFS had most of these ingredients. In general, CFS did have documentation, transparency, price discovery and uniformity. But one of the drawbacks was that it didn't have special margin. Special margins are needed because if the share price goes up too much, obviously there is a chance of it going down as well, and so there should be special margin. The margin should increase as share prices go up, because the risk increases accordingly.
The other thing is that the margin should not be in the form of shares, because when stock market falls the margin also decreases. Therefore, the margin should be in the form of cash and not in the form of shares.
What about the volatility in the stock market? Well, stock markets are generally volatile. But our stock market is very volatile. If you look at the volatility of other stock markets, they are in the range of 15 percent or so, our stock market volatility is about 20 to 22 percent.
So, although the return has been historically quite good at KSE, as a product, it hasn't been very successful. If you look at the return of Pakistan stock market in past many years, it has been quite decent in the range of 14-16 percent annually. But it's not the return, it's the volatility that keeps the investor away, so we need to reduce the volatility and that's where the mutual fund industry can play some role by bringing products in the market, which are less volatile than the stock market.
Aside from these adopting trading related measures, what else should be done to get the bourse in shape? There are a lot of companies in the market - about 300 to 400 -- which are very small, their market capitalisation is small, their liquidity is low, and therefore they basically don't add too much value.
So, one good thing that is probably needed in Pakistan is that small companies should merge together, to form one large company, or form one holding company and bring several small companies under that - so small companies de-list and come back as a large company.
Not only will it bring economies of scale in terms of operations of the business that they do, but when stock market capitalization increases, the volume will increase, and the combined company will deserve a higher price-to-earning ratio and a higher price-to-book ratio.
Do you think this model is especially needed in the case of textile sector companies? I think it is the need of the hour. A lot of these textile companies don't have economies of scale because they are small, so they need to merge. How should these firms get about this whole delisting, merging and then re-listing process? What can the regulator do?
At the regulatory side there should be some facilitation, however, this is more of a commercial decision. SECP rules exist about forming a subsidiary, which enable a company to do so; for example Engro has recently formed Engro Corporation, which is a holding company.
But it's more of a commercial decision; it's more of a visionary thing that rather than running it as a family business, I want to become a shareholder in a very large company and that could bring economies of scale.
What measures are needed to get more firms listed at the bourse? Do you think the laws are too stringent, which doesn't motivate the firms to get listed? There used to be a tax benefit to get listed, which is no more there. But I don't think the companies should get listed just for the tax benefit. Companies should get listed because basically it increases their visibility and helps them finance themselves both from the equity market and the debt market. So they should come for other reasons rather than just the tax reasons.
Is the corporate finance function of brokers and investment bankers partly to blame for their failure to reach out and convince private firms to get listed? Well, they should do that. But you see some things are determined by the market. Plus, these things evolve over time. Our culture is family business and it takes a while before things change. When I was in Saudi Arabia it was difficult to convince even large corporations to raise capital from the exchange.
But more importantly, brokers are to be blamed for not expanding the base. Pakistan stock market has been there for more than 60 years and there are less than 300,000 UIN numbers, compared with 35 million bank deposit holders, in a country of 170 million people. The brokers have focussed only on few investors and they have made them trade excessively.
If instead of limiting themselves to few high net worth individuals, had they set up branches across Pakistan - selling stock, bonds, and money market instruments -- they would have done better for themselves, for the investor and for the country.
Would that help increase listing? Yet, if we have three million investors in the stock market than having 300,000 investors, then obviously it would create an environment where more and more companies would want to get listed because they could get a good premium for that.
But don't you think it is costly for brokers to go out and expand their outreach? You see when you expand it takes some time period; you cannot have a return overnight. If I want to make money in the long term, I should set up my branch network. And I might have to wait five years, but its going to pay off in a big way. That's where I think is the shortcoming.
But do you think it's also a problem of perception management, because even when brokers reach to attract more investors, many people say 'oh, the stock market is one big gamble'.
Yes that's right. But let me tell you the ABC of investing of what we are taught. We should take only those people to the stock market, who do not need the money for the next five years or ten years. Simply, don't take short term investors in the stock market because market is very volatile in the short term. So if somebody needs to send his kid for studies in a year, or marry his daughter, or build a house in a year or two, we should not advise him to invest in the stock market.
Unfortunately, the mindset that the brokerage community has created here is that come today, go out tomorrow, then come again and go out the next day. Rather than setting up an investment mindset, we have set up a speculative mindset and this is why it becomes a gamble in the short term.
On a daily basis, nobody can predict what the market will do; it becomes a random walk, with 50 percent head and 50 percent tail. But look at 5 years or 10 years period in the history of Pakistani stock market, and you will see that generally it has performed better than banks, it has done better than inflation, and it has even done better than defence saving certificates.
How many brokers do you think actually give such advise to their clients? Probably a few and this is where the SECP has to play a role to improve disclosure requirements for brokers.
And mutual fund industry? We are advising that, but remember we are a new industry. For example if you come to NAFA saying that you want to invest, we will first ask you to fill out our risk profile questions, and based on that if we see that you are risk averse and that you need money in the short term, then we would never advise you to invest in our stock fund, we would ask you invest in a government bond fund.
Where does transparency fit into all of this? Well, if you look at the return on equity of some of these listed companies - good years or bad - it has been like 10 -12 percent. My question to them is that if you are earning only 10-12 percent, why don't you sell your company and put your money in a bank and make the same 10-12 percent.
The fact is that these companies are earning more than 10-12 percent but they are not disclosing all their profits in their accounts and this way they are not only cheating the small shareholder but they are also cheating the country of taxes.
So how can this be resolved then? One of the things that need to be done is that the Federal Bureau of Statistics or any other appropriate department should keep the details of market prices for all types of product and services. Obviously these might differ from region to region, but those can be accounted for.
Then when it comes to finalisation of the company's balance and sheet and income statement, it is the auditors' responsibility to ensure that the prices that have been taken, both on the input and output side, fall within the range of market prices. And this is where I think the disclosure requirements have to be improved.
In fact, the audit department and the tax department both should ensure that the prices shown by the company fall within the range of market prices. This way it will become difficult to evade taxes. Does this mean that you are for a stronger role of cost and managerial accounting and also a more transparent disclosure of the firms' costing, considering that details of cost accounts are not made public?
Yes, that's where the disclosure requirements should improve. If you look at other countries especially the United States where I have worked previously, a lot of these details have to be disclosed in the accounts and the auditor has to make sure that these prices are fairly close to the market prices. These disclosure requirements should not just be for listed companies but for all companies.
Therefore, the SECP has to come in to ensure that both listed and unlisted firms disclose their financial information properly. But again there is a cost to it. If disclosures requirement increase then so will the cost of preparing them and accordingly the cost will also increase at FBR's end. Do you think it is justifiable under cost-benefit analysis considering that we are living in a poor country?
You see we are also living in a country which pays only 9 percent of GDP in taxes. There are obviously other angles to it; in my view, all income should to be taxed, whether it is agricultural income, stock market gains, real estate gains, income from services, etc.
But still within the services and manufacturing sector, several companies still do not disclose a lot of their financial information and that's where it is important to have better disclosure.
Some cost will increase but you must also see that the costs of earning only 9 percent of GDP in revenues are very high; what percentage of people are not going to school because of that, what percentage of people are not getting basic health care services and so on.
What's your view on the bond market? In Pakistan, the bond market, whether it is government bond or the corporate bond, is very small.
World-wide the corporate bond market is four five times bigger than the stock market, whereas here, it is just a fraction of the stock market. And this is one of the reasons why Pakistan hasn't developed. If you look at countries like India, Malaysia, Indonesia, Singapore, Thailand, they have developed their bond markets much faster and bigger than us.
What happens here that when a large AA rated company needs financing, it goes to an A-rated bank and takes a loan. In the outside world, a high rated, a AA-rated company would take it as an insult to go to an A-rated bank and ask for a loan. They basically, on the strength of their own balance sheet, issue a commercial paper if they have short-term needs, which we call the money market. And if they have long term needs like five-year or ten year requirements, they issue a bond. This enables, the banks to focus on lending to the small and medium businesses.
Here, banks find it comfortable to either invest in the safe government bonds, or give the money to first tier companies; as a result the small and medium size borrower suffers.
What are the authorities doing about it? This is something the governor State Bank is quite aware of. Earlier this year, he called a number of CEOs of the asset management companies and advised them to expand their base, saying that the industry should launch government and corporate bond funds.
He is of the view that we should free the banks to lend to small and medium companies rather than financing the government or first tier companies, who should issue their own commercial papers or bonds. Government bonds should actually be purchased by mutual funds and not banks; this is how it is done world-wide.
How had been the fund industry's response? NAFA was the first one to launch a government securities liquid fund. We launched it in May and the fund is already over Rs 5 billion, so it has been quite successful. The problem is that Pakistani mutual fund industry had lumped together the money market and the bond market. The funds we had were neither money market funds nor bond funds.
Investors then realised that there could be volatility in it and when this volatility came, investors took the money out. So we sat down as an industry and in consultation with the SECP, we decided to have separate funds for stock, bond and money market.
Why do you think the recently launched bond trading system at the KSE hasn't been able to attract volumes? In the stock market all investors, whether it is an individual or an institution, are required to trade through the system. However, in the case of BATS, we are still waiting for SECP to issue instructions that all trading have to take place through BATS. Unless this happens, there will be problems in terms of price discovery, in terms of transparency, in terms of liquidity, efficiency and documentation.
Are these instructions in the pipeline? Yes, these are in the pipeline, we have heard from the SECP that they will do it soon. Once it happens, we will see volumes improve and we will see more investors coming in. But it's not going to happen overnight.
Does this mean that TFC issuance will increase then? It could, but there is another issue. When a company goes for listing a TFC, it has to get approval from SECP. At the time of application for the TFCs, it already has a rating and so the SECP shouldn't take a lot of time to approve its listing.
Once the SECP sees that procedural requirements are there, it should give the approval in a week's time. but because the SECP in general takes a lot of time on this, a lot of companies have preferred for privately placed (non-listed) TFCs. The problem is that they are not liquid because they do not trade on the exchange. So, we need to ensure that the privately placed TFCs are also given some kind of a technical listing so they can also start trading on BATS. And in the future, SECP should make TFC issuance very convenient.
Is this because there is a trust deficit between the rating agency and the SECP? If they have a trust deficit then they should work it out with the rating agency, the SECP should not start evaluating each company that wants to list its TFC. They don't have the resource base to do that and it's not their job. If SECP thinks, ratings agencies are not doing the right, and there have been question marks raised on the rating agency, then they should sort it out with them.
What is your personal evaluation of the rating agency? Almost 40 percent of the A-rated TFC have defaulted in the last couple of years. I think a bad economic environment is to be blamed, but I think at the same time rating agencies need to improve their standards.
There are some companies, which are in genuine trouble and some companies that are not. But it has become a culture that they would just come to the TFC holder or the banks and they say they are in deep trouble and that they want restructuring on good terms.
And the trouble is that whether it is a bank or the TFC holder, the options are limited because if you go to the courts it would still take several years. So knowing this, the companies exploit it, they default, they come back to us, and they want us to restructure at low rates, and give them an extra grace period of say 3 years and this hurts our investors.
What should the SECP to do meet these challenges? Well, they are already in the process of hiring good talent, but I think they need to hire more commissioners. And they also have to move to Karachi
Any plans of you joining the regulator? No I have a company which is still young and I have to grow the company. I cannot afford to move out at this stage, may be five or seven years down the road I will look at that option.
In this interview, Dr Amjad shares his thoughts on the issues and challenges faced by Pakistan's capital markets, including the lack of documentation and transparency, the need for regulators to step up their performance and the responsibilities of the brokerage and asset management industry. The following are edited transcripts.