Governance issues undermine capital markets

Wednesday, August 13

The Karachi Stock Exchange has recently been subject to volatility after several years of strong performance. Political uncertainties and a worsening economic climate are partly responsible for this, but institutional and governance issues are also a concern.

Riots broke out at major stock exchanges last month after a significant plunge on the Karachi Stock Exchange (KSE). The KSE 100 index has been particularly volatile recently in the face of falling confidence since the February election, political uncertainty, growing economic worries and a worsening security situation on the western border.

Yet it has gained international prominence during the last couple of years due to its buoyant performance. It is often described as one of the most liquid exchanges in the world:

As of May 30, 654 companies were listed on the KSE.
Total market capitalisation is currently around 50 billion dollars, the result of a significant increase in the past few years.

More broadly, capital markets have benefited from improvements in infrastructure, a clearer regulatory environment (with the creation of the Securities and Exchange Commission of Pakistan (SECP) in 1999), and growing foreign interest, although this has declined in recent months.

Yet capital markets face serious long-term challenges, many of which are institutional in nature:

They are still far from achieving the key developmental objective, which is to raise long-term capital for firms. The ratio of equity market capitalisation to GDP is 44%, which represents a significant increase over recent years, but is still significantly less than some other Asian countries such as Malaysia, where this ratio is 138%.
Stock markets have a low investor base, with few individual investors participating in the stock market.
A few investors dominate the KSE: roughly about 30 companies account for 90% of turnover. Allegations of insider trading and price manipulation are common.
The dominance of speculative activity is heavily dependent on the notorious system of 'badla' financing, which is unique to the local market and has contributed to crises. Under badla, funds to meet settlement obligations are traded between speculators and financiers in continuous open auction trading.

Several regulatory problems need to be addressed:

Neither the SECP nor the KSE have properly conducted investigations into market scams or reined in unscrupulous dealers.
Rules have been changed overnight to prevent broker defaults when there is a risk of a sharp fall or when speculation appears to be growing out of control.
Despite years of structural reforms, the SECP is facing pressure from political and business lobbies. Even though the SECP is constitutionally independent, it is a different matter on the operational front.

Thus despite improvements in infrastructure and regulation, capital markets in Pakistan continue to face key challenges, including attracting individual investors, commanding greater market confidence and raising long-term finance.