Stock Market in Pakistan : An Overview 1 Stock Market in Pakistan : An Overview By

This paper reviews the main features of the Stock market in Pakistan focussing on postliberalization period. The aspects of the market investigated include liberalization of the market, integration the market with the world markets, trading and settlement mechanism, and corporate governance issues. Finally salient features of the market are compared to a selected set of emerging and developed markets. Pakistan’s stock market is smaller in size but is significantly more active than the markets of this size. In recent years the market has provided very high returns to investors. In 2002 the market was declared as the best performing stock market globally. Stock Market in Pakistan: An Overview 3 Stock Market in Pakistan: An Overview 1. NTRODUCTION The Karachi Stock Excahnge (KSE) is Pakistan’s first and one of the oldest stock exchanges in emerging markets. KSE was established in 18 September 1947 just two months after Pakistan became an independent state. The other exchanges in Pakistan, the Lahore Stock Exchange (LSE) and the Islamabad Stock Exchange (ISE), were estbalished in 1974 and 1997 respectively. A recent estimate shows that approximately 85% of the turnover occurs at KSE, 14% at LSE and 1% at ISE. The following discussion is devoted to the KSE unless otherwise stated. At the end of year 2007, 671 companies were listed on the exchange with a combined market capitalization of US$70.18 billion and listed capital of US$12 billion. According to the Pakistan Economic Survey (2007), for the fiscal year 2006-2007 Pakistan’s GDP is estimated to be US$143 billion. This makes market capitalization approximately 49% of the GDP. The most popular index tracking the overall prices on the market is the KSE-100 index which is a market capitalization weighted index of 100 stocks consisting of top market capitalization companies from each of the 34 sectors. The remaining 66 firms are selected on the basis of market capitalization without considering sector. The securities traded in the market include ordinary shares, preference shares, redeemable certificates and term-finance certificates (corporate bonds). The ordinary share is the most traded security. Since 2003, futures trading in some active stocks also started. The exchange Stock Market in Pakistan: An Overview 4 plans to start options in the near future and according to their estimate by 2012, 50% of the trading will be in the derivatives. Table 1 reports some statistics showing trends in the market over the post-liberalization period. The KSE-100 index and market capitalization in 1998 dropped as a result of sanctions on Pakistan over the issue of nuclear tests. However, there is no visible impact of sanctions on trading value and turnover. The drop in the number of companies from 2001 to 2002 was in response to the implementation of the code of corporate governance in 2002. Some companies voluntarily de-listed as they found the code too costly to implement. Since 2001, the market has seen a rapid growth in capitalization and trading volume. Despite its relatively small size the market has came under the limelight in recent years. According to the International Finance Corporation (1992) it was ranked third according to percentage increase in the local stock market index in 1991. More recently in 2002 Pakistan was reported to be the best performing market in the world according to the US news magazine Business Week. This performance continued in the following three years albeit to a lesser extent. According to the Country Report for Pakistan by International Monetary Fund (2004), improved macroeconomic conditions, low interest rates, excess liquidity, and better regulation and supervision in the market were the factors that fuelled this rapid rise. With respect to the turnover ratio the market was Stock Market in Pakistan: An Overview 5 ranked first and third in 2003 and 2006 respectively (Global Stock Markets Factbook, 2004; 2007). 2. LIBERALIZATION OF THE MARKET According to Henry (2000), stock market liberalization is expected to reduce the liberalizing country's cost of equity capital by risk sharing between domestic and foreign investors. An important prediction of this argument is to observe an increase in physical investment and subsequently economic growth following stock market liberalizations because a fall in a country's cost of equity capital will enhance the viability of investment projects that will foster subsequent economic growth. Starting in the early 1990s many emerging markets liberalized their capital markets by allowing foreign portfolio investment. Pakistan’s market was officially liberalized in February 1991. According to Uppal (1998), the opening of the market to foreigners was abrupt and complete and was announced in the form of a comprehensive package aimed at deregulation and privatization of the economy. This includes lifting restrictions on the holding of foreign currencies and transfers of dividends and capital gains, allowing foreign companies to engage in exports and other trade liberalization policies. Issues and transfer of shares to foreigners were no longer required to have prior approval. However, the State Bank of Pakistan’s permission is required to transfer more than 5% of shares in banks or financial institutions. There is no restriction on foreign ownership of stocks except in life insurance companies. Stock Market in Pakistan: An Overview 6 Bekaert and Harvey (2003) show that for the case of Pakistan real GDP growth declined and real investment growth became negative after liberalization. Further, in Bekaert and Harvey (1997) study, Pakistan is the only emerging market for which volatility after liberalization has greatly increased. A similar impact was also reported by Kim and Singal (2000). Thus the impact of liberalization on Pakistan’s economy and the market does not appear to be positive at least in the years immediately following official liberalization. One interpretation of this outcome is that the market is liberalized but may not be integrated. Another reason might be that perhaps some other factors negate the impact of liberalization. For instance, in the post liberalization period, political instability could be gauged by frequent government changes in a short period. This period is also characterized by large budget and current account deficits and small foreign exchange reserves. A sequence of currency devaluations in 1995 to 1997 and negative impact of sanctions on Pakistan’s economy after its nuclear tests in 1998 may also be considered as factors that might have influenced the impact of liberalization. 3. INTEGRATION OF THE MARKET IN THE WORLD MARKETS The question of whether stock markets are integrated has gained enormous importance in the empirical literature in the last two decades. According to Bekaert and Harvey (2002) asset returns in segmented markets are determined by the local risk factors and associated risk premia while for integrated markets global risk factors and global risk premia are relevant. Recent studies are more inclined towards portfolio allocation benefits. The economic motivation behind these studies is to establish whether some markets provide diversification gains. The simplest measure of market integration is provided by the correlation coefficient between the country stock market indices. For Stock Market in Pakistan: An Overview 7 the period February 1993 to January 1996, Smith and Walter (1998) report that the correlation of Pakistan’s equity market with the US market is -0.01. In Harvey (1995) the correlation of Pakistan’s equity market with the Morgan Stanley Capital International (MSCI) developed market index and the overall world market index is reported to be 0.02 and 0.04 respectively. Table 2 reports more recent evidence in this regard. Table 2 reports correlation of Pakistan’s S&P/IFCG price index and aggregate indices of selected countries. It appears that the correlation of Pakistan’s equity market with developed markets is still very small. Relatively larger correlation is observed with regional markets such as India and other emerging markets especially with those of Latin America. To investigate integration of equity markets, Korajczyk (1996) used a measure of integration based on pricing errors from an international APT model. Using monthly data of 52 stocks from Pakistan’s market for the period 1984-1992 he reports that pricing errors for Pakistan are relatively smaller but contrary to the intuition, the pricing errors were higher in the post-liberalization period. More recent studies have employed cointegration and Vector Autoregression (VAR) to test dynamic linkages of stock markets. Hussain and Saidi (2000) used cointegration analysis to investigate integration of Pakistan equity market with the developed markets of US, UK and Japan among others. Although cointegration was found, which indicates that prices of Pakistan’s equity market move with these markets, any causal effect of these markets on Pakistan was not detected. This observation led them to conclude that Pakistan’s equity market has diversification potential. Similarly, Naeem (2002) found cointegration of Pakistan’s equity market with the US and UK in the pre-nuclear test period ranging from January 1994 to April 1998 Stock Market in Pakistan: An Overview 8 but not for the entire sample including a later period. Using weekly country level index data from November 1987 to November 1999, Darrat and Zhong (2002) analyzed the permanent and transitory impact of US and Japan’s equity markets on a set of 10 Asian markets including Pakistan. They found that, like most other countries in the sample, Pakistan’s market appears to be driven permanently by the US market but the effect of the Japanese market is transitory. More recently Lamba (2003) used cointegration to test the dynamic relationship of the South Asian equity markets including Pakistan, India and Sri Lanka with the developed markets. Using m