Pakistan Stock Exchange (PSX) index was downgraded from Emerging Market to Frontier Market recently by MSCI (Morgan Stanley Capital International). Some people are linking this subject to the state of Pakistan’s economy. They are correct, albeit partially, as in the past such actions had been used in support of some other presumptions. I seek to correct the perception about the relationship between the capital market’s status and the state of Pakistan’s economy.
I served as the First Chairman of the Regulatory Affairs Committee of PSX as a government-nominee Director of KSE/PSX for three years after bourse’s demutualization. Furthermore, I have worked as a Partner and Senior Partner of the largest accounting firm that serves as the External Auditor of major companies listed on the exchange. Presently, I serve as the Member Board of two major listed entities in Pakistan.
It is important to identify the reasons why a particular section of our people that represents potential investors does not invest in shares in PSX. They opt for National Saving Schemes. There is a question why listing and investment in PSX has not received the kind of reception and support from the larger community in Pakistan, at least in terms number of persons involved. This needs to be critically examined in the light of recent action of MSCI.
MSCI is an independent organization and they have their international standards to guide the potential investors in various stock markets. Pakistan cannot afford to ignore their actions and categorisations. Potential foreign investment in Pakistan stock market largely depends on observation and sentiment conveyed by these organizations. It appears that the MSCI action and the realities on ground in the PSX have very little relationship with the state of Pakistan’s economy; at least in the last twelve to eighteen months.
The reasons for reclassification by MSCI are:
“Although the Pakistan equity market meets the requirements for Market Accessibility under the classification framework for Emerging Markets, it no longer meets the standards for Size and Liquidity”
The main reason is the size and liquidity in the exchange. There are two elements involved in this matter. One has no relation with any matter related to PSX whereas the other which in my view is extremely important relates to PSX. The size of the market and entities being traded in Pakistan has reduced, as against the past, due to a substantial devaluation of PKR against the USD that occurred in 2018 and 2109. As a result of this devaluation the USD value of scrips being traded in the exchange has decreased in dollar terms which is the basis of calculation by the MSCI in terms of size.
The other factor is related to liquidity that is the ‘Free Float’ of scrips available in the market. Under the present regulatory requirement there is an identified procedure for free float of scrips in the market. The question here, which is also relevant to MSCI, is whether such a level is sufficient keeping in view the potential available for investment in PSX.
Before dilating on this matter it is important to refer to a verifiable fact that the ‘Results’ announced by almost all the major listed companies in the Financial Statements released in the past few months have shown substantial improvement over last year. In this situation, as persons conversant with the economy of Pakistan, it should be our duty to identify the metrics that lead to such actions by relevant organizations like MSCI.
On the basis of improvement of economic indicators in the recent period the first impression that emerges from this action of MSCI is to ascertain the level of relationship between PSX status/index and state of Pakistan’s economy. On the basis of facts as indicated below such a relationship is not there in reality as it is perceived for various reasons. Some of the reasons are indicated as under:
The proportion of economic assets/ activity of the country that are directly or indirectly reflected in entities on the PSX is a very small percentage of total assets/activity. For example, out of total economic activity of around USD 450 billion (GDP) in a year, only 20-30 percent is actually directly reflected in entities listed on PSX. All the remaining parts of assets/activity are not directly or indirectly related to the listed sector;
Even within the PSX ‘free float’ is a small part of the assets/activity of the entity. If we take a bold estimate, that proportion will not even exceed 15% of the assets/activity of that entity. This effectively means that total reflection of economic activity in the country is 15% of that 35% being 5 percent only.
It is therefore not correct to state PSX index’s variation and its grading has any direct relationship with the state of economy of Pakistan. It may only be a sentiment that in many situations is not related to the overall sustainable economic state of the country. As a student of economics and finance, it is my firm view that there is an urgent need to improve this situation if there is a desire to create a documented, secured, all-inclusive capital market in the country. We cannot attract institutional foreign investment in emerging businesses unless we are able to demonstrate that our capital markets fulfill the necessary requirements of a near-to-perfect market. The MSCI decision constitutes a wake-up call.
If we closely analyze the recent downgrade, then it transpires that this action has, inter alia, been undertaken for the reason that a very low percentage of total shares of an entity are traded in the exchange. This affects the size and liquidity of the market. In simple words, it means that in majority of cases the shares available for investment (which is actually trading in real sense) constitute a very limited percentage of total share capital of that company. In other words, an overwhelming majority of issued shares are held by the sponsors of the entity and consequently not traded on PSX. Accordingly, prices do not necessarily reflect the long-term sustainable value. International investors are interested in a near-to-perfect market and are therefore not ready to consider PSX as an emerging market. Their perception is correct only to this extent. It is our duty to correct the situation if there is any desire to obtain long-term sustainable investment in PSX from international investors. In my view, even the potential local investors do not want to take the risks which are not really there but are highly perceived.
The first step for correction is to accept the fact that everything is not just right on PSX and at SECP (Securities Exchange Commission of Pakistan) with respect to this deficiency. As a national policy we have to increase the number of market participants. As per my information, the total number of such participants has not increased as was desired in the last two decades. The second indicator is to identify the kind of investors in the new listings. Though there is no exact identification however it is commonly seen that bulk of such people are ‘traders’ in shares rather than investors. Unless a substantial number of non- majority owner investors’ clusters are developed there cannot be any question of a near-to-perfect capital market. We all know that people used to invest in certain companies as long-term investors. Now that position is not the same. An easy/affordable opportunity is to be provided to general investors in the new scrips. The regulatory mechanism for new listings is to be completely revamped.
Throughout the world the real long-term investors in capital markets are retirement funds, trusts, charitable institutions and others. In Pakistan, however, it is not the case. In my capacity as a Trustee in many institutions I am fearful about investment of Trust funds on PSX. Resultantly, all such funds are invested in National Saving Schemes which are effectively non-productive in real sense. There has to be a system whereby such institutions that are interested in long-term investment are attracted to the market. If that is not done there cannot be any sustainable improvement in the PSX and we will remain a ‘trading’ and volatile unpredictable market. International institutional investors will leave and only those who look for short-term gains will come to the country.
The problem has been partly identified as aforestated. Now solutions are to be considered. There can be two kinds of solutions. First, the regulatory solutions whereby certain regulations are placed for revising free floats of shares available in the market and other such measures. The second kind pertains to institutional approaches and policymaking. I am not in support of any regulatory kind of solution. We cannot force sponsors to undertake their affairs in the manner we desire. We have to create an environment where there is a possibility of long-term sustainable investment by persons other than sponsors. Unless this is done the primary problem will not be solved. Some of the possible solutions are:
Elimination of all kinds of taxes for shares held for more than three years; and tax credit against taxable income for investments held for over three to five years in the third or fifth year as the case may be;
Stock Market Guarantee Insurance for institutional investors like retirement funds and trusts for their long-term investments;
Re-designation of PSX index; there is an urgent and serious need to review the manner of determination of the PSX index. Under the generally accepted principle, the function of deciding the manner of determination of index is placed outside the ambit of the stock exchange to improve confidence of the public at large and avoid conflict of interest. Such a function is assigned to independent financial entities such as FTSE, Dow Jones and others. This subject will be dealt with in a separate write-up.
Simplification of Stock Exchange Regulations and improvement in transparency including removal of perceptions of market manipulation;
Transparent and secured market mechanisms including merger of NCCPL and CDC into PSX as functions being undertaken by these entities are those which are to be undertaken by the exchange. Data present at three places simultaneously is prone to be abused. There may be cost-savings also;
Reducing regulatory compliance by listed entities in comparison to unlisted entities; and
Long-term investments by banks be allowed for the purposes of statutory reserves requirement (SLR).
Our capital markets will remain subject to shocks like the present one in the absence of much-needed corrections. We have to create an environment for a near-to-perfect market if we are interested to be a part of the international community of investors.
To conclude, it can be said that there is an urgent need to take into account the reasons for recent downgrade. It is true that this is definitely not a reflection of the state of Pakistan’s economy which has improved in the recent past.
Copyright Business Recorder, 2021