Reality of the KSE
The faulty barometer
By F.S. Aijazuddin
It could not have been comfortable for the managements of the stock exchanges at Karachi and to a lesser degree Lahore to be confronted by their signal failure as monitors. It could not have been any easier for the SECP and the State Bank of Pakistan to accept criticism of their brazen role in a scheme by which, because of their intervention, ‘managers of public institutions undertook losses arising from pre-arranged transactions using public money, in clear violation of their institutional mandates.’ The intervention the task force report alluded to was an arrangement by which financial institutions, under the aegis of the State Bank and the SECP — and with the benediction of someone in government — agreed to buy OGDC shares at Rs 117.50 per share from a range of sellers who were expected to default on their futures contracts. The intention was to avoid a collapse of the markets. The pre-facto reality was that fears about a contagious default on the stock exchanges “were exaggerated, and the situation did not warrant ... any intervention contrary to market rules.”
Why then did the government and all its safety valve regulators suffer this panic attack?
To explain this collective paranoia, one needs to remind oneself of the continuing sensitivity of the present government to oscillations in the KSE share index. The white paper that reviewed its performance over its first three years of governance from 1999 to 2002 crowed that, “as a result of market friendly policies pursued by the present government, the stock market in Pakistan has recorded unprecedented growth during the last three years. The KSE share index grew ... from 1189 points to 2014 points.”
Those were modest beginnings. By 2002-03, it had touched 3,400 or so points, then 5,300, and in 2004-05, at the time of the government-assisted intervention, it had soared to 10,303 points. As in the story of Jack and the beanstalk, only the sky was the limit.
To outsiders observing this unnatural phenomenon, this rise was inexplicable. The KSE index seemed to be going up even though the total volume of shares traded was decreasing. To insiders, the causes were all too clear: too many brokers were speculating on too few scrips. And this became apparent to the task force when it discovered that ‘0.1 per cent of investors accounted for 98 per cent of the turnover’, just one broker traded over Rs 115 billion worth of shares in only six stocks, and that the shares of only five companies — OGDC, NBP, PSO, PTCL and POL — constituted 60 per cent of the KSE index (which includes 95 other companies). Consequently, when the market collapsed in March 2005, these five scrips plus PPL (which at that time was included in the KSE Index) were responsible for 75 per cent of the fall.
Speculation at this level in stock exchanges, especially in such provincial ones as the KSE and the LSE, is rarely as a result of a lemming-like mass movement of small shareholders, led on by impulses they cannot control. In a bullish market, every buyer hopes to make a profit, and every seller wishes he had waited to make an even bigger one. It is this very expectation of profit that is the engine of any stock market, and that drives the two and half provincial stock exchanges we have in Pakistan at Karachi, Lahore and Islamabad. A shadow concomitant of the formal trading structure operating within the local stock exchanges is the badla market, an arrangement under which buyers who need financing borrow at rates that fluctuate according to usurious supply and helpless demand. The total financing in the badla market in March 2005 was Rs 33 billion, of which 70 per cent was against shares of the five companies mentioned earlier, most of which coincidentally were in the public sector.
Because badla financing is scrip specific, providers of badla financing can withdraw such financing support selectively, trapping speculators who have over-extended themselves. When the providers of badla financing are the very brokers who have pre-sold scrips in the futures market to speculators, they are in the enviable position of being able to finance their own victims. The unwritten convention is that the rates of borrowing are raised or lowered to winnow demand. At Karachi, the rate in March 2005 was increased from 18 per cent to 24 per cent while at Lahore which is uncapped it went as high as 100 per cent.
Badla financing for scrips such as PTCL and PSO was first withdrawn by financiers and then restored. “Since OGDC was still considered too risky to finance by badla providers, the weakholders of OGDC had to be bailed out with public money through NIT, SLIC and NIC.” This was the outcome of meetings held on March 27, 2005, between the SECP, the KSE, interested and affected brokers, compliant public institutions, and the State Bank. “It is amazing that no minutes have been recorded of this meeting [held at 11.00 pm at the SECP offices at Karachi], nor has any basis been provided for taking these decisions.” In effect, private speculators were bailed out by a consortium of public institutions led by NIT and including such meek cash cows as SLIC and NIC, an intervention that “in effect saved some private investors using public funds.”
Was such a selective bail-out necessary? The task force did not think so: “The mere default by some brokers and investors would not have threatened the integrity or reputation of the market, in which default is one of the normal potential outcomes anyway.”
Being prudent men, and brokers are after all honourable men, the stock exchanges have schemes that provide safety nets for its members and their customers. In the event of a default by a broker, his creditors would have first claim on his personal assets (which would include his seat, valued in Karachi at Rs 60 million) and then could in theory at least look to the Clearing House Protection Fund of Rs 684 million and the Investor Protection Fund of Rs 386 million.
In the March 2005 debacle, these were not tapped. Instead, without waiting for the buyer parties to default, public money was used to prevent the possibility of private failures and to provide sellers with profits they might otherwise have had to forgo.
Gradually, as the market is moving towards paperless scrips and arbitrage is becoming less arbitrary, badla financing will be relegated, despite its popularity for whereas margin financing is construed by the tax authorities as being interest income and therefore taxable in the hands of the recipient, the profits from badla financing are tax-exempt for being capital gains.
By F.S. Aijazuddin
It could not have been comfortable for the managements of the stock exchanges at Karachi and to a lesser degree Lahore to be confronted by their signal failure as monitors. It could not have been any easier for the SECP and the State Bank of Pakistan to accept criticism of their brazen role in a scheme by which, because of their intervention, ‘managers of public institutions undertook losses arising from pre-arranged transactions using public money, in clear violation of their institutional mandates.’ The intervention the task force report alluded to was an arrangement by which financial institutions, under the aegis of the State Bank and the SECP — and with the benediction of someone in government — agreed to buy OGDC shares at Rs 117.50 per share from a range of sellers who were expected to default on their futures contracts. The intention was to avoid a collapse of the markets. The pre-facto reality was that fears about a contagious default on the stock exchanges “were exaggerated, and the situation did not warrant ... any intervention contrary to market rules.”
Why then did the government and all its safety valve regulators suffer this panic attack?
To explain this collective paranoia, one needs to remind oneself of the continuing sensitivity of the present government to oscillations in the KSE share index. The white paper that reviewed its performance over its first three years of governance from 1999 to 2002 crowed that, “as a result of market friendly policies pursued by the present government, the stock market in Pakistan has recorded unprecedented growth during the last three years. The KSE share index grew ... from 1189 points to 2014 points.”
Those were modest beginnings. By 2002-03, it had touched 3,400 or so points, then 5,300, and in 2004-05, at the time of the government-assisted intervention, it had soared to 10,303 points. As in the story of Jack and the beanstalk, only the sky was the limit.
To outsiders observing this unnatural phenomenon, this rise was inexplicable. The KSE index seemed to be going up even though the total volume of shares traded was decreasing. To insiders, the causes were all too clear: too many brokers were speculating on too few scrips. And this became apparent to the task force when it discovered that ‘0.1 per cent of investors accounted for 98 per cent of the turnover’, just one broker traded over Rs 115 billion worth of shares in only six stocks, and that the shares of only five companies — OGDC, NBP, PSO, PTCL and POL — constituted 60 per cent of the KSE index (which includes 95 other companies). Consequently, when the market collapsed in March 2005, these five scrips plus PPL (which at that time was included in the KSE Index) were responsible for 75 per cent of the fall.
Speculation at this level in stock exchanges, especially in such provincial ones as the KSE and the LSE, is rarely as a result of a lemming-like mass movement of small shareholders, led on by impulses they cannot control. In a bullish market, every buyer hopes to make a profit, and every seller wishes he had waited to make an even bigger one. It is this very expectation of profit that is the engine of any stock market, and that drives the two and half provincial stock exchanges we have in Pakistan at Karachi, Lahore and Islamabad. A shadow concomitant of the formal trading structure operating within the local stock exchanges is the badla market, an arrangement under which buyers who need financing borrow at rates that fluctuate according to usurious supply and helpless demand. The total financing in the badla market in March 2005 was Rs 33 billion, of which 70 per cent was against shares of the five companies mentioned earlier, most of which coincidentally were in the public sector.
Because badla financing is scrip specific, providers of badla financing can withdraw such financing support selectively, trapping speculators who have over-extended themselves. When the providers of badla financing are the very brokers who have pre-sold scrips in the futures market to speculators, they are in the enviable position of being able to finance their own victims. The unwritten convention is that the rates of borrowing are raised or lowered to winnow demand. At Karachi, the rate in March 2005 was increased from 18 per cent to 24 per cent while at Lahore which is uncapped it went as high as 100 per cent.
Badla financing for scrips such as PTCL and PSO was first withdrawn by financiers and then restored. “Since OGDC was still considered too risky to finance by badla providers, the weakholders of OGDC had to be bailed out with public money through NIT, SLIC and NIC.” This was the outcome of meetings held on March 27, 2005, between the SECP, the KSE, interested and affected brokers, compliant public institutions, and the State Bank. “It is amazing that no minutes have been recorded of this meeting [held at 11.00 pm at the SECP offices at Karachi], nor has any basis been provided for taking these decisions.” In effect, private speculators were bailed out by a consortium of public institutions led by NIT and including such meek cash cows as SLIC and NIC, an intervention that “in effect saved some private investors using public funds.”
Was such a selective bail-out necessary? The task force did not think so: “The mere default by some brokers and investors would not have threatened the integrity or reputation of the market, in which default is one of the normal potential outcomes anyway.”
Being prudent men, and brokers are after all honourable men, the stock exchanges have schemes that provide safety nets for its members and their customers. In the event of a default by a broker, his creditors would have first claim on his personal assets (which would include his seat, valued in Karachi at Rs 60 million) and then could in theory at least look to the Clearing House Protection Fund of Rs 684 million and the Investor Protection Fund of Rs 386 million.
In the March 2005 debacle, these were not tapped. Instead, without waiting for the buyer parties to default, public money was used to prevent the possibility of private failures and to provide sellers with profits they might otherwise have had to forgo.
Gradually, as the market is moving towards paperless scrips and arbitrage is becoming less arbitrary, badla financing will be relegated, despite its popularity for whereas margin financing is construed by the tax authorities as being interest income and therefore taxable in the hands of the recipient, the profits from badla financing are tax-exempt for being capital gains.
posted by India News Watch at 10:03 AM
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