Pakistan’s irrational exuberance.
By: Tarique Khan Javed
President, Overseas Pakistani Investors Forum.
Dated 16 Dec 2008
As the events of post floor market unfolds with expected losses in line with trading in “off market” reaching minus 30% level, during the floor, it is pertinent that we trace sources of the current crisis and recommend some remedy.
It must be borne in mind, that Pakistan’s Equity market, since inception, has always been an un-attractive market. With very limited dividend payment Investors always felt cheated. The KSE 100 Index moved within 1000 level until the first Nawaz Sharif government, considered business friendly, came to power and the Index touched 2,500 levels. But fell again after his departure. On the eve of 9/11 the market was at 1,500 it fell to 1,000 levels after the event.
The rise of KSE 100 above 6,000 level, was never justified by economic fundamentals and no one pointed this out. The State Bank Governor could have repeated the famous “irrational exuberance” remark by US Fed Reserve Chief Alan Greenspan at the height of NASDAQ rise to above 5,000 level from 1,300 before 9/11, but she kept quite. So did other responsible in the Government like SECP Chairman and Advisor Finance.
Independent Analyst also either did not realize what was going on or deliberately kept quite. This allowed the vested interest like Stock Brokers beating their drum, urging people to put all their money in stock exchange, as according to them, the rates were very attractive on PE ratio basis. Electronic media also failed in its duty to warn people of the scam. As a result millions of ordinary pensioners, widows, orphans and young investors have lost a substantial saving.
It is feared that most of the big brokers are bankrupt and their bankruptcy declaration is on hold till the market falls to its real level. These Brokers instead of keeping their activities to brokering only reportedly, indulged in massive speculation using their client deposit as margin. Now they have lost enormous sums which can not be covered by selling all their assets including membership cards.
Event of 9/11, low inflation and interest rate helped the market:
As Arab investor and Overseas Pakistani felt uneasy keeping their money in the West after 9/11, they were forced to look at markets like Pakistan. With limited number of shares the prices started to shoot up. Many buyers chasing few shares. Thus by April 2008 the index touched 15,700 levels.
During 2002 and 2006 the inflation rate was lower and so was the interest rate. This encouraged huge borrowing from Banks. It is estimated that Banks lent more during this short period compared to total lending since independence. An unprecedented consumer expenditure boom; financed by borrowed money, ensued for the first time in Pakistan’s history. However as specter of inflation rose as a result of widening budget deficit all this started to slow down and now with 29% inflation and lending rate of 20%, has come to a halt.
Fall inline with rest of the World:
The fall from 15,700 to 9,180 levels was justified on the basis of prevailing international and domestic circumstances and it was in line with drop in Chinese, Russian, Indian and US markets. Most markets lost 50 to 70% of their value. However barring few days none of the market was closed down. Some markets have
recovered already. Few brokers lost money as they sold shares as the threshold of margins crossed in an open market. However in the case of Pakistan with market
semi closed before the floor and almost closed after, the bid offer rate become so divergent that no trade could take place on the basis of screen price. Thus brokers could not sell the share and minimum margin level crossed leading to their losses. There own speculative position suffered more severally.
Structural changes in operative environment:
Markets do go up and down due to many factors of demand and supply. They also reflect structural changes in global arrangements. For instance Japanese NIKKIE
had touched 40,000 reflecting Japanese supremacy as Economic power. However when USA forced it to appreciate its exchange rate against USD from 240=1 to 140=1 as per 1985 Plaza Accord, Japan lost its comparative advantage and over the next few years the Index dropped to 10,000 level by 1990.
In the case of Pakistan 9/11 brought an unexpected demand for its share and the Index rose. Seeing the rising market speculators all over the world also got involved
and gave the index further support. The local investors also joined the Band wagon to the delight of Brokers and Stock exchange. However as the sub prime crisis started to emerge the credit lines started shrinking and Overseas speculators started to sell off their holding. At the same time inflation in the Country crossed double digits, followed by increase in deposit rates making the earlier relative earning comparison unattractive for Equity investment. The rise is lending rate led to sharp drop in demand which was fueled by bank borrowing at cheap rates. Consumer loan default increased which further reduced lending by Banks.
Equity markets relationship with Inflation and Interest rate
As a consequence of the inflation the deposit rates have moved upto 16%. Therefore the return on our equity market has become unattractive at current levels. A return of 16 on deposit implies PE ratio of 100/16 =6.25. In order to beat this; the Equity market must have a PE ratio of 5. In order to get that ratio our market should fall to 6,356 level. That means a drop of 2,823 or 31% from the pegged level of 9,180.
Once we reach the PE level of 5; Pakistani market would look attractive to foreign investors. At that level we shall perhaps beat other countries and become one of the cheapest markets. Provided they also do not fall further.
Equity market’s relationship with Foreign Exchange market:
Foreign investors play a key role in Pakistani Equity market. As Pakistan rupee fell in recent month from pegged level of 62 since 2004 to 78-80 levels they lost money at the time of transfer outside on top of loss in the value of shares. This fact is likely to deter their reentry till such time that they feel that PRS has found its economic equilibrium level.
As per my calculation that level is around USD 1= PRS 93; to account for at least 50% inflation since 2004, when the rate was artificially pegged at Rs 62. The pegging was possible because lot of investment was flowing in the Country, including USD 4.5 billion in Stock market. Now that the hot funds are going back keeping currency at artificial high level will not be possible. Out of the Stock
market alone USD 2.3 billion has already gone out and remaining 2.2 is in the process of going out from 15 Dec 2008.
Adjustment of FX rate to its correct equilibrium level is central to correcting the current trade deficit and run on our FX Reverse. If this not done the USD 7.5 billion IMF fund will used up paying for high Import bills, while our Export remain
in-competitive owning to artificially high FX rate, in the wake of substantial increase in local cost since 2004.
NASDAQ’s fall from 5,400 to 1,300 after 9/11:
When this massive drop happened, within weeks, I was Credit Manager of a large Brokerage House of my Bank in Gulf. By selling shares on time we escaped any loss as a Bank, although investors suffered heavily. The lesson learned was that the
House should sell the share as soon as the margin call is not fulfilled by the client. This should happen the same day, as no one knows what will happen the next day.
The negative impact of inflation on economy:
Once inflation is allowed its consequences can not be avoided for long. Following always happen:
- Increase in interest rate (Phillips Curve).
- Depreciation of currency value in FX market.
- Drop in Export and increase in Imports.
- Drop in Equity market.
- Rapid increase in poverty.
- Social and political unrest.
- Confused investment climate locally.
- Flight of capital.
Delay in taking corrective action only compounds the problem. The only way to avoid these dire consequences is; by not printing notes beyond the economic growth level.
Market with 5% loss floor will not work:
The cumulative effect of folly after folly is that the shares are now traded in off market transaction at 30% discount. At this juncture SECP has finally ordered opening of the markets from 15 Dec 2008 with 5% lower lock.
Common sense says that this will not work as no one will buy share through the system at maximum 5% discount while he can buy the same at 30% discount. The result will be that there will be lots of seller and no buyers as now. In order to kick start the system SECP must insist on no lower lock until market drops by 30% or to KSE 100 index at 6,426; thereafter 5% lock may be introduced.
In this manner the market is expected to stabilize at around 6000 level which will reflect 400% increase over 11 Sep 2001 level or 55% annually, for 7 years and 3 months. Quite an impressive growth by international standards!
What the investors should do now?
The losers in this market are only the ones who entered the market above 6,000 level. They have to accept the loss. They should sell their shares immediately if it is bought with borrowed money. However Investors who have invested their own money should not sell their shares at this stage and hold on to their holdings. They should keep their focus on the dividend income and not worry about ups and downs of the market.
On paper those who invested when market was below 6,000 level, became very rich when market touched 15,700 level and now they have lost substantial sum of the occurred but not realized wealth. They have to accept this un realized loss with grace and hope that inflation and interest rate will ease off and economy will start growing again at a faster pace, to lift the market again. I believe this will happen in the long run.
