Light at the end of the tunnel

PSX aspires for best global practices as country implements regulatory reforms

The integration in January 2016 of the Karachi, Lahore and Islamabad stock exchanges into a single platform that created the Pakistan Stock Exchange turns a new page for the country’s capital markets. The regulators are instituting a host of reforms to enhance governance practices and attract more investors into its markets

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14 Dec 2016

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Nadeem Naqvi, who took over the stewardship of the Karachi Stock Exchange (KSE) in 2011, probably helped the exchange avoid the worst of the 2008 crisis that crashed markets and wiped out over a trillion rupees in Pakistan’s exchanges. “It was all about firefighting when I came over five years ago,” says Naqvi, who now heads the new Pakistan Stock Exchange (PSX) after KSE’s integration with the country’s two other exchanges in January 2016.

“The biggest challenge then was the need for a culture change in the organization, bearing in mind that the brokers, who were also the stakeholders, had just been through tough times. This has taken a lot of time, but we are finally seeing the light at the end of the tunnel,” Naqvi tells The Asset as he describes earlier efforts to put KSE, now PSX, back on track.

Indeed, the Pakistan stock market has come a long way since the 2008 market meltdown that drove KSE to set a floor on the market. Naqvi laments this to be equivalent to imposing capital control. During the past years, the regulators have been enacting a host of market reforms to regain the trust of investors, including the demutualization of the three individual exchanges – Karachi, Lahore and Islamabad – ahead of the integration of their trading platforms to create the single exchange or PSX.

The clincher came on June 14 this year when the MSCI announced it is reclassifying MSCI Pakistan Index back to emerging markets status to coincide with the May 2017 semi-annual index review.

The index – that has 16 constituents covering about 85% of the equity market – was designed to measure the performance of the large and mid-cap segments of the Pakistan equity market.

The announcement sent the benchmark KSE-100 index to an all-time high at over 38,000 points. Pakistani brokerages have raised their outlook on the market with the index projected to rise to as high as 41,000 points by year end. The PSX was already one of the best performers in Asia this year with the KSE-100 index gaining 15% ahead of the MSCI announcement.

While the actual reclassification of the index will happen in 2017, the Egyptian based investment bank EFG Hermes has said it expects the upgrade to generate inflows of global investment amounting to US$475 million by the middle of 2017.

Pakistan was part of the MSCI emerging markets index between 1994 and 2008, but the temporary closure of the KSE in 2008 led the MSCI to remove it from the index and classified it as a standalone country index. MSCI relegated the index to the frontier markets index in May 2009.

 
A look back
The creation of PSX was more than a decade in the making. Its launch on January 11 2016 marked the dawn of a new era in Pakistan’s capital markets. As of June 15 2016, the PSX has 577 listed companies with a market capitalization of US$74 billion.

Looking back, Naqvi believes Pakistan has learned a great deal from KSE’s knee-jerk reaction to the 2008 market crash.  “Policy-wise, it was a major disaster,” notes Naqvi. “You can impose a short halt in trading, or you can close the exchange for a day or two, but you cannot put a floor because that was equivalent to a sort of capital control.”

That episode left such a negative impression on the market, especially among international investors. But Pakistan moved to remedy that years later. In 2012, Pakistan Parliament passed the Stock Exchanges Act 2012 aimed at revitalizing the stock market.

The implementation has come in several phases. The first of was the corporatization and demutualization of Pakistan’s three stock exchanges in 2012 ahead of their integration into a single exchange in 2016. The exchanghes’ real estate and stock exchange operations eventually were split into two separate legal entities. The real estate assets of KSE constitute roughly 50% of its net capital.

The final phase will involve the sale of a 40% equity stake in PSX to a strategic investor, with 20% of its shares to be offered to general investors ahead of its listing in 2017.

The demutualization act forced all the three stock exchanges in 2012 to initiate reforms in their operations, including the appointment of a director from the Securities and Exchange Commission of Pakistan (SECP) to their boards that brought in better governance practices.

“We brought in private sector focus in running the exchange such as on revenue generation and looking after cost,” he says. “And instead of just sitting and hoping that the investors would come, we started an investor awareness campaign in schools, business community and even among the housewives.”

As Naqvi recalls, a survey conducted three years ago among the Pakistani savers showed that investing was at the bottom of their priorities. “People view the stock market as a speculative area since there was too much volatility,” he points out. “So one of the things that we’ve started doing was to create a systematic programme of going to smaller towns outside of Karachi and explain to people how returns from stock market investing can outpace inflation and earnings from bank deposits.”

In addition, the KSE then strengthened the brokers’ capability, rolling out in September 2015 the 75 million rupee internet trading platform called KiTS to help them handle their clients’ trading activity.

Small retail investors
The small number of retail investors participating in the stock market was to Naqvi quite alarming. “On a net basis, we only have 250,000 individual retail investors and it was quite shocking considering that the number of Pakistani bank accounts was in excess of 25 million,” he says. “They were simply not approached properly in terms of the use of stock as an investment vehicle.”

In contrast, the number of overseas investors in the Pakistani market is on the rise. The SECP has released a white paper on making mandatory for all listed companies to have a 25% free float. Naqvi notes that Pakistan in the 1990s levied listed firms a tax rate that was 10% less than that imposed non-listed firms. So companies naturally flocked to the markets to save costs – not necessarily to raise capital. But that privilege was gradually taken away and fewer companies wanted to list.   

“The IPO (initial public offering) market crashed as nobody wanted to list. The valuations were very low and it does not make sense for the sponsors to come into market and give part of their wealth. We only had one listing in 2009 and it has been an uphill battle throughout,” says Naqvi.

But the exchanges started reviving IPO roadshows and lured at least nine listing in 2015 and a number more this year. “The IPO environment is improving, but overall we’re still facing significant challenges as we move forward,” says Naqvi.

New brokerage category
Another issue facing the PSX involves the brokerage industry itself. Naqvi explains: “For a country such as Pakistan, having 400 brokerage houses do not make sense. It is a fragmented industry. If we take the top 50 brokers, we are talking about 85% of the total traded volume. So what do the rest of the houses do?”

To address this issue, the SECP has accorded its approval to the Securities Brokers (Licensing and Operational) Regulations 2016. A key aspect of the new regulation is to classify which brokers are into trading and those that are into clearing. As a rule, only financially-sound brokerages can perform custodial functions. There will be easier requirements for brokers that are not involved in custody or clearing functions

“This is a major step in the right direction,” says Naqvi. “It will improve the governance practices and enhance the credibility of the entire capital market.”

In its divestment exercise, the PSX announced on August 16 that it has received a strong feedback from foreign and local investors in response to its invitation for expression of interests (EOIs) for acquiring equity stake in the exchange.

As a result of extensive campaign and persistent follow-up, the PSX received by the end of deadline on August 15 a total of 17 EOIs from investors applying under the categories of strategic investor, anchor investor and financial institution. 

PSX wants to ensure that the interest of the brokers that own PSX shares are protected. At the same time, it plans to take on a strategic partner that can institute real change in PSX. “For the owners, the focus is on pricing, what they can receive for their shares and what the plans are of the potential investors to take the exchange to the next level,” says Naqvi. “And as a regulator, we will be looking at the reputation of the buyer, their technological capability and their ability as an exchange operator to take the Pakistan market and integrate it into the global system.”

Going forward, there is a lot going for the PSX. As Naqvi points out, several large companies are expanding. They need to raise money to fund their expansion and many of them are exploring raising cash via a rights issue. Cement companies, for instance, are doubling their capacity during the next two years, he cites. Big auto players are likely to access the market for funding. Banks, meanwhile, will be issuing both tier 1 and tier 2 capital to meet their Basel II requirements.

A bigger chunk of the PSX activity will also come from the government that needs to raise funds for projects tied to CPEC. Naqvi says power sector projects with capacity of up to 10,000 megawatts are in different stages of development with some already cleared for licensing, others nearing a financial close and will eventually undergo construction phase that will require heavy funding. 

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14 Dec 2016

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