Pakistan: After the Crash

Irrational exuberance brought a crisis in the futures market in March. Now regulators hope reforms will restore investor confidence

By Naween A. Mangi

The tale of the Pakistan stock market has all the makings of a financial fable: dizzying heights, record-breaking numbers, and unfettered greed. It has grabbed headlines because of its race to new highs on the back of a powerful economic recovery with stunning corporate profit growth. And it captured the limelight in March when investors rioted at the stock exchange to protest heavy losses when the market crashed.

Pakistan's stock market started rising in early 2002, in the aftermath of 9/11. Economic performance improved, liquidity in the market rose, and investor confidence increased under the government of President General Pervez Musharraf (see BW Online, 4/20/05, "India and Pakistan: A Peace Payoff"). Over the three years from Dec. 31, 2001 to Dec. 31, 2004, the benchmark Karachi Stock Exchange 100-share index rose 388%, from 1,273 to 6,218. During the same period, market capitalization rose sixfold, from $5 billion to about $30 billion.


  Why the euphoria? Economic performance in Pakistan improved significantly as a result of extensive structural reform. In 2004, Islamabad successfully graduated from an International Monetary Fund program, ending years of dependence on the fund. GDP growth, which languished around 3% in 1999, will surpass 7% in the year ending June, 2005. A stable exchange rate, record foreign exchange reserves, and growing exports made for a historic economic turnaround.

Liquidity increased following 9/11, when expatriates began sending more money home to avoid probes by U.S. and Middle Eastern authorities. Home remittances rose from $983 million in 2000 to almost $4 billion last year, and a lot of that money found its way into the booming share market. It helped that interest rates also fell to historic lows -- from 12% in 2001 to 2% in July, 2004 (as measured by the benchmark short-term Treasury-bill rates) -- leaving stocks as the best investment avenues, with bank deposits returning below inflation and historically high-yielding state-run savings schemes drastically cutting double-digit rates of return in line with IMF conditions.

Strong economic growth also led to a corporate revival. Earnings growth has averaged 20% over the past few years, with listed companies trading at attractive price-earnings multiples and promising high dividend yields.


  The country's privatization program also took off, and the government's strategy to divest significant holdings through the stock market paid handsome dividends. In the last 12 months, the shares of major oil and gas sector companies, among others, were divested through the stock market. The shares of five major state-run companies have sold through the share market for $285 million since July, 2003.

In a country in which only 1% of the population invests in stocks, the privatization strategy served to increase participation and broaden the investor base. The 2004 issue of Kot Addu Power, a power-generating unit in northern Pakistan, attracted as many as 1.4 million individual investors, the highest number ever to participate in an initial public offering.

"Just everybody was getting into the act," says Tariq Hasan, chairman of the Securities & Exchange Commission of Pakistan, in Islamabad. "The 'irrational exuberance' that was once talked about in the U.S. took on a whole new dimension here. And as regulators, we can regulate the market, but not irrational market behavior."


  And there was plenty of that to go around. Fueled by the ongoing privatization story, which generated bullish sentiment, speculators bought heavily in the futures market. The rally continued to gather speed in 2005. Between Jan. 1 and Mar. 15, the index had climbed 65% and slammed to an all-time high of 10,303 points.

The frenzy had reached historic proportions. "Women have been grabbing me at the opera and beseeching me for tips," says Arif Habib, chairman of Arif Habib Securities, one of the major brokerage houses in Karachi. "This level of interest in the stock market has never been seen before in Pakistan."

Foreign investors also began to look at a market they had shunned since 1998, when the government conducted a round of nuclear tests that resulted in severe economic sanctions. Data from the State Bank of Pakistan, the central bank, shows that net foreign investment in the share market amounted to $82 million between July, 2004 and February, 2005, compared with a net outflow of foreign investment of $38 million in the same period the previous year.

But before foreign investors could settle in, the inevitable happened. The index plummeted 25% in just eight trading sessions after Mar. 15, producing the largest single-session decline in the market's history, 4.6%, that day. The decline was stemmed only by a regulation that dictates individual stocks automatically lock if they fall 5% in a single session. By Naween A. Mangi


  The futures buyers consisted mostly of retail speculators. When the settlement date came, they were unable to pay for delivery because they had counted on selling out beforehand. The 5% lockup kept them from doing so. Dreams and fortunes crumbled, and panic reigned.

Eventually, a consortium of financial institutions bought shares that investors were stuck with, and some calm returned. But the jitters have since continued, and the market has remained volatile, ending Apr. 21 at 7,101, down 31% from the high on Mar. 15.

Soon after, the Securities & Exchange Commission beefed up regulations increasing margin requirements for futures trading, making the collection of loss margins on an hourly, rather than daily, basis and promising to introduce a client identification system in November. The SEC also set up a task force this month to investigate the causes behind the crash.

What's next? Brokers say corporate profitability remains strong, and continued economic growth will fuel the trend once investors regain confidence. "Foreign investors should see that the market is now down some 30% from its peak, and there are some phenomenal opportunities in it right now," says broker Habib. "Given that corporate earnings growth is at a historic high this season, current share prices are a steal."


  Regulators plan to get the market back on track by forging ahead with the reform program that began in 1997. Previous changes have included bringing nonbroker directors onto the board of the exchange, introducing fully automated trade, and improving market monitoring.

Hasan says in the next eight months he plans to convert the exchange from a mutualized body owned by brokers to a for-profit company owned by shareholders, phase out the age-old carryover transactions system and implement an internationally favored margin finance system, and put an end to the group accounts system at the Central Depository Co., where brokers set up accounts under which all clients trade. "It is essential that we put an end to these three things for the stock market to become devoid of manipulation and market abuse," he says.

Hasan has his work cut out for him. Although the recent regulatory changes have helped, Pakistan's share market is reputedly manipulated by a handful of large players, mostly brokers, through large-scale speculation. Broker resistance to reform will likely remain strong, keeping the market shaky.


  But restored strength will also depend on certain external factors. To put a cap on growing inflationary pressures in the economy, the central bank has begun to raise interest rates. This change may pull some money out of stocks and into other investment vehicles.

The future of the government's privatization program will also affect investor sentiment. Two of the country's biggest state-run corporations -- Pakistan Telecommunications and Pakistan State Oil, a petroleum marketing company -- are to be sold off this year. Since they rank as two of the highest-traded companies on the stock exchange, privatization-related news could have a wide impact on the market. The privatization effort has, however, suffered delays several times over the last few years. If further holdups occur, market sentiment could suffer.

Finally, domestic political stability and security and the continuation of peace talks with India will also prove critical in keeping investor nerves calm and focused. But if reform is successful and the environment remains conducive, market experts are predicting the 10,000 level will soon be a reality once more.

Mangi is a correspondent for BusinessWeek in Karachi

Edited by Phil Mintz

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