Capital Market Reforms

PROBLEM & ITS BACKGROUND 1.1 INTRODUCTION A modern and efficient capital market is the backbone of an economy. It plays a crucial role in mobilizing domestic and foreign resources, and channeling them to promote investment activities both for the short and the long-term periods. No country can prosper without developing its equity market (Rizvi, 2002). Reflecting upon the Asian currency crisis, more attention is being paid to the importance of consolidation for the domestic financial and capital markets, as well as international cooperation to avoid disturbing factors from abroad, such as massive inflows of speculative capital (Kishi, 2002). The government of Pakistan and its respective regulatory agencies has been striving hard to tame negative speculations, restore investors' confidence and stabilize stock market for the last many years and numerous regulatory, financial and other corrective measures have already been taken to obtain these objectives. But even then, by the end of 1997, the index was at the bottom, market was vacillating between the spell of greed and gloom, investors were living in the state of despair and the country's financial image had been shattered. The market mechanism has not been working under the principle of demand and supply, as well as the economic fundamentals for as long as can be remembered (State Bank Report, 2000).

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The Capital Market in Pakistan has two main components: an Equity market represented by the three stock exchanges in Karachi, Lahore and Islamabad; and an intermediated financial system dominated by an increasing number of Non- Bank Financial Institutions (NBFIs). In the development of its capital markets, Pakistan has faced issues similar to those in other emerging markets in Asia. But the economic turmoil presents Pakistan with some unique problems. The downturn in the capital market dates back to late 1994. After several attempts to address the country’s macroeconomic imbalances and deep-rooted structural problems, shortcomings in policy implementation came to light, bringing the country to the brink of a foreign exchange crisis in October 1995. Between the end of 1995 and April 1998, the rupee depreciated by 24 percent. Since 1995, the threat of currency de-valuation has deterred foreign portfolio investment. From 1996 onward, deteriorating law and order in Karachi, the Government’s prolonged tussle with foreign independent power producers (IPPs), and the constitutional crisis in late 1997 all dampened growth of the capital market. In March 1998, the withdrawal of tax exemption granted to corporate holders of Term Finance Certificates (TFCs) also hit the corporate bond market (Chou, 1998). The country has already achieved a moderate level of capital mobilization through the bond and equity markets at 43 and 22 percent of gross domestic product (GDP), respectively, at the end of 1997. However, the figures are deceptive as government issues dominate the corporate bond market—with corporate bonds accounting for only 1 percent 2

of GDP. Similarly, the equity market became more skewed from 1996-1998, resulting in the top five stocks representing more than 70 percent of market capitalization by May 1998. Finally, in the aftermath of the nuclear tests of 28–30 May 1998, austerity measures were imposed. With the freezing of foreign currency accounts and sanctions imposed by G-8 countries, activities in the foreign exchange market almost ground to a halt and so did foreign portfolio flows. The currency plunged in the market amid fears of an impending debt default. Under the threat of a recession, the bond and equity markets received a grave setback. The negative market sentiment was reflected in the decline of the key Karachi Stock Exchange (KSE)-100 index, which plunged 56 percent during 1998, reaching a record low in July of that year (Chou, 1998). The first vital step taken by the government to counter all these problems was the dissolution of Corporate Law Authority in 1997 due to its total failure to manage the stock market and the involvement of some of its bosses in financial bungling. Constitution of the Securities and Exchange Commission of Pakistan (SECP), an independent and powerful regulatory body to purge rotten system, create level-playing field and bring all stakeholders under a new regulatory framework was another step in this regard. The establishment of the Central Depository Company (CDC) was also a milestone in the corporate history of Pakistan aiming to create transparency in trading, eliminate the trading of fake shares and facilitate electronic transfer.

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The Asian Development Bank (ADB) planned to substantially reform Pakistan’s securities market with the help of two loans totaling US$255 million approved in November 1998 for the Capital Markets Development Program (CMDP) (ADB, 1997). The ADB provided one policy loan of US$250 million for reforms intended to strengthen the regulatory and institutional frameworks to improve investor confidence, eliminate market distortions and modernize and upgrade the securities market infrastructure. The ADB also provided a concessional technical assistance loan of US$5 million equivalent for capacity building to implement the reforms. Repayment of the policy loan is over 15 years, including a grace period of three years. The ADB’s technical assistance loan is from the Asian Development Fund (ADF), the Bank’s concessional fund. The loan is interest-free and carries a service charge of 1 percent per annum. This is repayable over 40 years, including a grace period of 10 years (ADB, 1997). The capital market reforms are an integral component of the structural reforms being supported by the International Monetary Fund to restore macroeconomic stability and to build up the banking system, while developing a more conducive incentive regime for industry. The ADB program builds on this. Pakistan needs to develop its securities market to enhance resource allocation and to broaden and deepen the financial sector while at the same time providing alternative funding sources to industry, which has had to rely on Government-directed credit.

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The stock market has been hampered by weak infrastructure and regulatory restrictions on institutional investors who are required to invest a large proportion of their funds in Government securities. Key market participants such as mutual funds, insurance industry and leasing companies are prevented from playing a full role in the capital market by constraints such as tax anomalies, a predominance of the public sector and regulatory weaknesses. Market discipline and stability will be enhanced by the creation of a regulatory body, an independent Securities and Exchange Commission of Pakistan (SECP), to be operational by December 1998. The CMDP will eliminate repressive regulations and tax laws that have stifled growth of the equity and debt markets, with key initiatives to be effective in July 1998. These include the reduction of corporate tax rates for public and private limited companies, easing investment restrictions on institutional investors, and rationalizing the tax structure for private debt securities and mutual funds. The Ministry of Finance will be the executing agency for the policy loan and the SECP for the technical assistance loan. The Securities and Exchange Commission of Pakistan (SECP) has accelerated its drive to enhance the efficiency of the stock exchanges, ensure protection of the interest of investors and supervise the implementation of the reforms advised by the ADB. In short, Pakistani stock markets are on the road to better performance and efficiency. Although their volatility - an essential part of all emerging markets, creates higher risks they also magnify the potential for higher returns for any investor who has 5

the patience and sophistication to participate in the growth of this emerging market (Thaplawa, 2001).

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1.2 RESEARCH QUESTIONS This project aims to answer the following questions:  What are the reforms proposed by the Asian Development Bank as part of its capital market development program?  What is the aim of ADB behind these reforms?  How far has the Government of Pakistan worked to implement these reforms?  Whether the Securities Exchange Commission of Pakistan has faced any problem during the implementation?  What is their effect on the capital market in Pakistan?  Have the reforms been executed in their true spirit?  Have the support institutions like stock exchanges been supportive of the reforms?  Which reforms have not been executed so far?  What are the reasons behind the non- execution?  Will the reforms be applied in the near future?

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1.3 OBJECTIVE OF THE STUDY The objective of this research study is as follows:  To understand the aims and objectives of the reforms introduced by the Asian Development Bank in the recent years.  To study the implementation process conducted by the SECP (Securities Exchange Commission of Pakistan).  To understand the areas these reforms intend to target so that a critical analysis can be conducted so as to compare and contrast the target areas before and after the restructuring.  To find out if the implementation is according to the expectations of the government and ADB.  To study speculations surrounding the changes.  To find out whether the changes being carried forward are in fact positively affecting the operations of the capital market and how can the process of change be improved, if possible.

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1.4 SIGNIFICANCE OF THE STUDY A research on “A critical analysis of the capital market reforms introduced in Pakistan” is significant for understanding the various changes taking place in the Pakistani capital markets over the years since Asian Development Bank proposed its reforms. Capital market in Pakistan has experienced many ups & down in the past, due to frequent changes in the government and their policies relating to capital market. The equity market of the country had to survive in an atmosphere of uncertainty, which had mainly impacted the performance of the stock market in the 1990s (Rizvi, 2002). This study will give an in depth scrutiny of what has already been accomplished and what are the reforms’ implications, so that the people can believe the multi- pronged operation to cleanse the corporate sector specially with view to protect the interest of small investors and thereby restore their confidence in the stock markets. A policy environment can be created for enhancing competition and level playing. Most of the people in Pakistan are unaware of the working of the capital market and its significance in the economy of a country. This research will be an important step towards educating them about the various aspects of the capital market and how they can be effective participants in the economic development. Different aspects of these reforms aimed at improving the capital market have been highlighted and explained as to how they are effective and how investors can take advantage of them.

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SECP has managed to implement 30 principles of International Organization of Securities Commissions (IOSCO) that conform to international standards of securities market under the capital market reform program of the government in collaboration with the ADB, (Mirza, 2001). The significant improvement in the working of capital markets has been noticed both within and outside the country and any critical material on this topic is encouraged and published as well. The results obtained from this study can help the reader in getting a better understanding of the operations as well as the various factors (financial and nonfinancial) affecting the working of the Pakistani capital market. The impact of the reforms introduced in 1997 by ADB and implemented by the government of Pakistan and the level of success of these reforms in regulating the capital market and making it an attractive but safe venture for the investors, both domestic and foreign can also be understood.

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1.5 SCOPE & LIMITATIONS OF THE STUDY The subject/ content of the study is to analyze the capital market reforms introduced in Pakistan and their far-reaching effect once implemented. In order to make this research specific, the focus will be on the reforms introduced by the Asian Development Bank in 1997 and the activities of the Securities Exchange Commission in this regard. The time frame of the study covers six months, from March- August 2003. This study is challenged by certain factors, namely costs, time and scope. The study is aiming to cover the reforms introduced for the development of the capital market in Pakistan by ADB and Government of Pakistan. This is a broad topic and as such covering each aspect of the reforms in detail will prove to be a difficult task since the time and the information available may prove to be a serious limitation. There will be a limitation in terms of skill and education of the researcher, which still lacks sophistication and advancement in the understanding of the intricacies of finance and economics. Therefore the analysis may not be as professional as it can be. However, maximum efforts will be exerted to ensure authenticity and proficiency. Another limitation that can prove to hinder the researcher is the problem of accessing the related research articles and journals. The student has to depend on outside sources for information and encounters many tribulations in actually collecting the information.

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1.6 DEFINITION OF TERMS Bearish Trend: A falling market, characterized by selling a security in hope of buying it back at a lower price. Blue Chip: A large, well-established company with a history of profitable operation. Bonds: Fixed- income securities, which entitle the holder to a pre-determined return during their life and repayment of principle at maturity. Bullish Trend: A rising market, characterized by buying a security in the hope of selling it later at a higher price. Capital market: Markets in which longer-term financial instruments, debt and equity instruments i.e. bonds and shares, stocks are traded. Capital market consists of the institutions through which savings in the economy are transferred to investors. Stock exchanges, saving banks, investment banks and insurance companies are a part of capital market. Carry-over Trades: Equity repurchase transactions, better known as “Badla”, these are an established form of transactions used in the stock market for temporary financing of trades by speculators and jobbers. Dividend: That part of a company’s profits which is distributed among shareholders, usually expressed in rupee per share or percentage to paid up capital. Equity: The owner’s interest in a company’s capital, usually referred to by ordinary shares. Financial Markets: Financial Markets are all institutions and procedures for bringing buyers and sellers of financial instrument together. 12

Initial Public Offering (IPO): The offering of equity shares of a company to the general public for the first time. Insider Trading: The purchase or sale of shares by someone who possesses “inside” information on a company’s performance which information has not been made available to the market and which might affect the share price. In Pakistan, such deals are a criminal offence. Investment Companies: A company, which issues shares and uses its capital to buy securities and shares in other companies. Listed Company: A company whose securities are admitted for listing on a stock exchange. Market Capitalization: The total value of a company’s equity capital at the current market price. Option: The right (but not the obligation) to buy or sell securities at a fixed price within a specific period. Portfolio: A collection of Investments. Primary Market: Where a company issues new shares, either for the first time, or at the time of issuing additional securities. Privatization: Conversion of a state owned company to a public limited company (plc) status. Private Company: A company that is not a public company and which is not allowed to offer its shares to the general public.

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Public Limited Company: A company whose shares are offered to the general public and traded freely on the open market and whose share capital is not less than a statutory minimum. Rights Issue: The issue of additional shares to existing shareholders when companies want to raise more capital. Securities: A broad term for shares, corporate bonds or any other form of paper investment in capital market instruments. Settlement: Once a deal has been made, the settlement process transfers stock from seller to buyer and arranges the corresponding exchange of money between buyer and seller. Short Selling: The act of borrowing stock to sell with the expectation of price reduction with the intention of buying it back at a cheaper price. Stock Broker: A member of the stock exchange who deals in shares for clients and advises on investment decisions. Stock Market: The market place where shares of publicly listed companies are bought and sold. Yield: The aggregate return earned on an investment taking into account the dividend/ interest income and its present capital value.

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LITERATURE REVIEW In the inward-looking era of the 1950s, most countries’ domestic financial systems labored under extensive government restraint and were cut off from international influences by official firewalls. Despite these restrictions, which were a legacy of the Great Depression and World War II, international financial crises occurred from time to time. Between 1945 and 1970, however, their effects tended to be localized, with little discernible impact on Wall Street, let alone Main Street. Over the past twenty-five years or so this has all changed dramatically. Regional financial crises seem to have become more frequent, and the domestic impact of global financial developments has grown, to the alarm of many private citizens, elected officials, and even economists (Bacha, Lisboa, and Alejandro, 1982). Thus, the scope for capital markets to do good-or do harm-loomed larger as time went by. As an ever-greater part of national and international economies became monetized and sensitive to financial markets, agents in all spheres-public and private, labor and capital, domestic and foreign-were affected (Sylla, 2000). The relationship between financial development and economic growth is an issue that has also generated intense controversy; most theoretical expositions suggest that a well- functioning stock market can significantly influence industrial growth rate. But there are disagreements as to the direction of the effect on growth. While some development economists argue that financial development has little or no effect on 15

growth, others predict a strongly positive link between economic growth and financial development. However, there is little disagreement that a well- functioning market guarantees liquidity, risk diversification, acquisition of information about firms, corporate control and savings mobilization. Certainly, any changes in these factors will alter the rate of industrial growth (Udegbunam, 2002). For these reasons, the argument of those proposing a positive link between financial sector performance and economic growth appears more convincing. Financial development spurs higher economic growth by mobilizing savings. (Greenwood and Jovanovic, 1990) show how a well-developed financial sector can enhance economic growth by pooling savings. In particular, a well functioning stock market provides finance for long- term risky, but high return industrial projects rarely financed by other financial markets. This is because the stock market can pool together long- term funds needed for such projects; pooling of resources provide diversification, protects savers from idiosyncratic risk, and enables the stock market to fund lumpy and risky, though profitable, long term industrial projects (Montiel, 1995). A well-developed stock market promotes efficient allocation of the accumulated savings. The financial sector plays a role in channeling resources towards more profitable projects, or better investment opportunities (Becsi and Wand, 1997). By allocating resources more efficiently to profitable long- term investments, the stock market increases productivity in the real sector (Udegbunam, 2002).

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Another role of a well- functioning stock market, or financial system as a whole, is its ability to guarantee adequate liquidity. That is, investment in long term, high- return projects will be almost impossible without a liquid stock market or financial system. This is because savers may be willing to relinquish their funds if they are not assured of prompt and easy access to their savings when needed. A highly liquid stock market makes it possible for portfolio investors to acquire financial assets, and this enables firms to have access to long- term funds. The investors are encouraged to invest in these assets because they have access to their savings throughout the investment period. Thus a liquid stock market enhances investment in profitable projects with prospects for long-term growth (Bencivenga, 1996). A well- developed stock market also reduces investment risk by offering opportunities for portfolio diversification. The availability of different investment opportunities with differing risk characteristics encourages savers to acquire diverse investment assets, as this ensures minimum risk exposure (Levine, 1991). A well- functioning stock market improves corporate control, monitors managers, and stimulates information acquisition about firms. Ythe incentives for investors to obtain information about firms and improve corporate governance can be substantially increased by a developed, highly liquid stock market. When a stock market is liquid, an investor can use information acquired to trade quickly and easily at posted prices. The profit from such information will further spur investors to embark on supervision and monitoring of firms (Kyle, 1984). 17

Capital markets play a crucial role in mobilizing domestic and foreign resources, and channeling them to the most productive medium and long-term uses. Stock market development is positively associated with economic growth. (World Development Report, 2001). The importance of the stock market in the general equilibrium of the financial market has been duly recognized (Tobin, 1969). Moreover, a strong connection has been indicated between the predetermined component of stock market development and economic growth in the long run (Levine and Zervos, 1996). There is a close, if imperfect, relationship between the effectiveness of an economy's capital markets and its level (or rate of growth) of real development. This may be because financial markets provide liquidity, promote the sharing of information, or permit agents to specialize. As the efficiency of an economy's capital markets increases (the transaction costs fall), the general effect is to cause agents to make longer-term --hence, more transaction-intensive --- investments. The result is a higher rate of return on savings and a change in its composition. These general equilibrium effects on the composition of savings cause agents to hold more of their wealth in the form of existing equity claims and to invest less in the initiation of new capital investments. As a result, a reduction in transaction costs can cause the capital stock either to rise or fall (Bencivenga, Smith, and Starr, 1995). There is a statistically significant negative correlation between stock market development to firms' total equity. For certain developed markets, further stock market development leads to a substitution of equity for debt financing. In developing markets, 18

by contrast, large firms become more leveraged as the stock market develops, whereas the smallest firms appear not to be significantly affected by market development (Demirgüç-Kunt and Maksimovic, 1995). However, the assumption that shares in the stock market are considered to be perfect substitutes for bonds is not acceptable in the case of many emerging market economies, where domestic bond markets for foreign investment do not exist (Oblanchard, 1981). If equity markets are financially integrated, the price of risk should be the same across markets. If the markets are not financially integrate, possibly because of barriers to capital flows across markets, the price of risk may differ across markets. Large values of adjusted mis-pricing occur around periods of economic turbulence and periods in which capital controls change significantly. So, the adjusted mis-pricing estimates measure not only the level of deviation from the law of one price, but also the revaluations inherent in moving from one regime to another (Korajczyk, 1995). With public listed stocks, one can quantify the ownership mix and concentration, which makes it possible to study whether ownership structure significantly affects the performance of publicly, listed firms. There is a positive, significant correlation between concentration of ownership and profitability. The effect of concentrated ownership is greater with companies dominated by institutions than with those dominated by the state. A firms' profitability is positively correlated with the fraction of legal person (institutional) shares; it is either negatively correlated or uncorrelated with the fraction of

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state shares and with tradable A-shares held mostly by individuals. Labor productivity tends to decline as the proportion of state shares increases (Xu and Wang, 1997). Weak institutions—tangled laws, corrupt courts, deeply biased credit systems, and elaborate business registration requirements—hurt people and hinder development. Without effective institutions, people and developing countries are excluded from the benefits of markets. Countries that systematically deal with such problems and create new institutions suited to local needs can dramatically increase incomes and reduce poverty. These institutions range from unwritten customs and traditions to complex legal codes that regulate international commerce (Ryou, 2001). The financial reporting and disclosure problems, as well as the high market valuations for stock raise troubling questions about the functioning of capital market intermediaries, regulators and governance experts whose are supposed to ensure the effective functioning of the stock market (Healy and Palepo, 2002). The history of financial development has left behind a lot of lessons for today. Low inflation and sound public finance --- is important for creating the right incentives for facilitating the development of securities markets. High inflation and large fiscal deficits distort economic behavior in favor of short-term speculative projects and discourage the long-term investment projects conducive to sustainable economic development. Central bank independence may contribute to economic stability. One way to increase it is by lengthening the term of central bank governors. Developing effective 20

supervision (to ensure meaningful and effective compliance with prudential rules) is difficult and time-consuming but essential (Caprio, Jr. and Vittas, 1995). Two centuries ago, U.S. was a small, undeveloped country with serious financial problems. The British stock market did better than the U.S. market until the United States adopted security-market regulation (including disclosure rules) under the SEC. Then the U.S. market became a world leader. The U.S. stock market developed more slowly than the bond market, but it both aided and benefited from foreign investment in U.S. bonds. Foreign investors preferred debt securities to equities, yet equities create a safety margin for bondholders who, because of this margin, are more willing to purchase and hold bonds. Foreign investors preferred bonds; U.S. investors, after exporting bonds, held more stocks than bonds at home because good stock markets permit the conversion of equity securities into cash (Sylla, 1995). Looking at the experience of the financing pattern of the developed economies like the US and the UK, it was found that the corporate sector in these countries has followed a particular pattern of financing over the various phases of growth. In the initial stages of growth (firm and economy), the firms followed a path of financing from the external sources, mainly in the form of equity. But, with the expansion in the size and increasing risk of take-over, the ‘insiders’ adopted a strategy of an increased dependence on the internal (surplus) and external debt sources of financing. This pattern led to increase in the debt (debenture/bonds and various other hybrid debt instruments). In the latter half of 1980s, with the increasing significance of the emerging markets, there was 21

relatively increasing role of capital markets in developing economies. This opened up a new channel for sourcing investment fund for the firms. This new channel affected the structure of industries in these economies (Dhar and Murali, 2001). Financial systems in developing countries tend to be "restricted" or "repressed" through burdensome reserve requirements, interest-rate ceilings, foreign-exchange regulations, rules about the composition of bank balance sheets, or heavy taxation of the financial sector. Governments are regulating the financial markets to the point of financial repression (Denizer, Desai, and Gueorguiev, 1998). Experience has illustrated the ability of financial markets to innovate to manage risk exposures across markets and to circumvent official controls; it underscores the need for national authorities in emerging markets to understand the limited effectiveness of many restrictions that are being placed on financial transactions, lest institutions engage in a variety of unobserved and unregulated transactions (World Bank Report, 1997). Internal finance plays less of a role for Indian firms than for U.S. firms --- and external debt a bigger role. This is consistent with theoretical predictions, given that information and agency problems are less severe for Indian firms than for U.S. firms. Findings for India, with respect to stock market's role in providing finance, are generalizable to other developing countries. The development of stock markets is unlikely to spur corporate growth in developing countries. Foreign investors have played only a limited role in the slow-paced privatization of India's state-owned enterprises --22

although in recent years, despite delayed reform of the securities market, foreign institutional investors have begun to invest more. In emerging markets in Eastern Europe and Latin America, foreign investors have played a much more active role in privatization, chiefly by investing in those stock markets (Samuel, 1996). Capital markets throughout Asia, the Middle East and the Americas have been built and strengthened through (1) development and restructuring of regulatory agencies and other related institutions (2) review and revision of securities laws and regulations, (3) formulation of policies toward foreign and domestic resource mobilization, and (4) implementation of human resource strategies for securities market professionals and regulators (Aries group, 1999). Reforms and innovations have been most effective when they meet these needs in ways that are compatible with country conditions and increase access for the people. Learning from the success and failures of other countries' experiences in institution building can provide valuable guidance. But copying institutional models without considering whether they are needed by those they are supposed to serve, and the capabilities of governments and citizens, can waste scarce resources. For example, in the early and mid-1990s, Gambia and Zambia tried to establish stock markets by building stock exchanges and training people to staff them. However, there were so few listed companies and so little trading that the exchanges could not generate the fees to be selfsustaining. In hindsight, it is clear that conditions were not yet ripe for the creation of stock markets and the effort would have been better spent on other needs, such as 23

improving accounting and information systems (Ryou, 2001). In the development business there is a tendency to label approaches that have worked well in one or more countries as 'best practice' and then try to transplant these to other countries, When it comes to institutions, one size doesn't fit all (World Development Report, 2002). Development of the capital market includes establishing, strengthening and restructuring securities market institutions (such as regulatory agencies, stock exchanges, clearing and settlement organizations), intermediaries (such as investment banks, mutual funds, leasing companies, venture capital firms, brokerage houses), and activities (such as establishment of internal procedures and practices, development of appropriate organizational and staffing structures, formulation of strategic initiatives, and the design and implementation of customized management information systems). Existing securities laws are reviewed and revisions are recommended to reduce fragmentation, the enforcement powers of regulatory institutions are strengthened, and future use of new financial instruments are provided for, including asset-backed securities. Assisting regulatory institutions in drafting rules and regulations to cover all aspects of securities market operations, such as information disclosure, securities underwriting, brokerage activities, operations of mutual funds, margin trading, prudential safeguards, insider trading, etc. Reviewing the self-regulatory framework for exchanges, and recommending measures for improvement. Developing and conducting customized training programs and human resource development strategies for regulatory agencies, self-regulatory

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organizations, and market participants, including investment advisors and broker/dealers (Aries Group, 1999). A limited supply of financial instruments is not a major obstacle to the creation of pension funds and insurance companies. Such institutions build up their financial resources gradually but steadily, giving reforming governments ample time to develop securities markets. More important than the prior development of securities markets is a strong and lasting political commitment to holistic reform: macroeconomic, fiscal, banking, and capital market reform, as well as pension and insurance reform. So, institutional investors can serve as a countervailing force to commercial and investment banks, helping to stimulate financial innovation, modernize capital markets, enhance transparency and disclosure, strengthen corporate governance, and improve financial regulation (Vittas, 1998). Capital market development in emerging markets encompasses a wide range of activities, including institution-building, developing new instruments and mechanisms, in addition to creating and improving legal and regulatory frameworks. On the institutional side, it involves areas such as commercial and investment banking, insurance and pension funds, rating agencies and bond insurance companies (financial guarantors), private equity and venture capital, structured finance, derivatives, securitization, and securities markets. To do capital market development effectively takes a broad range of tools including debt instruments, guarantees, advisory and technical assistance work, equity and quasi-equity (IDB, 2000). 25

The dramatic improvement in the emerging markets over the past several years has been stimulated by three factors. First, the search for higher yields—a key feature of developments in mature markets—spilled over into emerging markets. As investors were forced to move down the credit spectrum in order to maintain yields, there was a strong increase in the demand for high-yield sovereign and corporate bonds issued by emerging market countries. Second, the continuing drive by institutional managers to increase their exposure to emerging markets and to achieve greater diversification of portfolios provided an important stimulus for flows to emerging markets. Third, the clear recognition by investors that the economic fundamentals in most emerging markets in the 1990s have vastly improved over those that prevailed in the late 1970s (IMF, 2000). In the earlier period, many heavily indebted emerging market countries had pursued development strategies based on import substitution, which involved using capital inflows both to finance large fiscal imbalances and to offset the effects of cap-ital flight. Fiscal imbalances often contributed to rapid inflation and a highly overvalued exchange rate. By contrast, in the 1990s a broad set of emerging markets pursued a strategy of opening their economies to international trade and capital transactions, fiscal consolidation, inflation stabilization, and extensive structural reforms designed to improve their economies’ overall efficiency (IMF, 2000). Well-designed private sector transactions can play a key role in the capital market development. Such transactions, with a high demonstration effect, contribute to consolidating market reforms and shorten the emerging markets' learning curve, by 26

transferring financial structuring know-how and market instruments from major markets (IDB, 2000). Open capital markets potentially bring enormous benefits to all-especially developing countries. They can supplement domestic savings, encourage the efficient use of scarce capital, and bring collateral improvements in know-how. But the Asian crisis brought home the need for countries to take greater care in the way in which they liberalize, especially if they lack sound financial systems. It is clear that liberalization has to be done in stages, with due regard for the soundness of the financial market as a whole (Ouattara, 1999). A number of factors have helped propel private capital flows to the developing capital markets. These factors included, first, the low level of interest rates and the compression of corporate bond spreads, which prompted fixed-income investors in the mature markets to move down the credit spectrum and search for higher yields on emerging market debt. Second, improved economic performance in many emerging markets reduced perceived credit risks. Third, institutional investors in the mature markets continued to seek the benefits of portfolio diversification in the emerging markets. Fourth, innovations in financial markets improved the ability of investors to manage exposures and risks to emerging markets, increasing the attractiveness of such investments. Fifth, continued financial and capital account liberalization in many emerging markets encouraged inflows. Finally, improvements in the availability and

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quality of information on emerging markets facilitated improved asset selection and assessment (World Bank, 1997). A remarkable development in the composition of external financing by developing markets in the 1990s has been the increased reliance on bond issuance as opposed to bank lending The favorable environment for emerging market borrowers in global bond markets prompted several sovereigns to launch issues to restructure existing liabilities at improved terms several entities placed century (100-year maturity) bonds, including the People’s Republic of China, the Israel Electric Corporation, India’s Reliance Industries, and the Endesa Chile Overseas Company. International placements of equity by emerging market entities rose during 1996 but remained subdued compared with the previous peak in 1993 (World Bank, 1997). The role of capital markets is critical not only for the crisis-affected economies but also for all vulnerable economies. The Asian crisis highlighted one important lesson: short-term foreign capital cannot finance long-term projects. Domestic sources of longterm funds are needed. However, long-term bond markets cannot be developed without improved corporate governance or an expanded investor base. Until equity markets are strengthened, the capital market cannot function well to complement the banking sector (ADB, 2000). Reflecting upon the Asian currency crisis, more attention is being paid to the importance of consolidation for the domestic financial and capital markets, as well as 28

international cooperation to avoid disturbing factors from abroad, such as massive inflows of speculative capital. The aim of the financial reforms being executed in the East Asian countries, such as Japan, Korea and China, is to improve the managerial efficiency of the business corporations and financial institutions (Kishi, 2002). The crisis that consumed Thailand, Korea, and Indonesia was stemmed from excessive credit expansion, financial sector weaknesses, and other structural shortcomings. It then turned into a capital crisis, sparked by a massive outflow of funds from these countries. This was a systemic problem, a crisis of the international financial system. The problem was that the system had not yet developed enough to reconcile the needs of all the participants—investors seeking new opportunities, emerging market economies seeking resources for investment, and governments seeking to ensure that markets were operating safely and efficiently (Ouattaram, 1999). The existence of well-functioning securities markets would have reduced the impact of the Asian crisis by enhancing the confidence of international investors, by improving market discipline, by promoting more effective allocation of capital and thereby reducing the incentives to withdraw from the market. Capital market development might have reduced the heavy dependence on the banking sector and foreign borrowing for project finance. The absence of well-functioning corporate bond markets may have deprived the public of credit information generated by such markets on a continuous basis. The lack of liquidity in the crisis-hit countries was further increased by the low supply of investment-grade paper, the insufficient number of intermediaries, 29

and the high trading costs due to fixed brokerage commissions. Illiquid futures markets may also have limited the hedging opportunities of market participants (Yoshitomi, 2000). Malaysian authorities implemented controls on international capital flows late in the Asian crisis, when most of the portfolio outflows had already occurred. The exchange rate had depreciated sharply and was fixed at an undervalued level, making further capital flight unlikely. The turnaround in the stock market, the return of positive GDP growth, the building of reserves, and the relaxation of interest rates all coincided with the imposition of controls. But the same changes took place in other crisis countries that did not follow the same control policies. However, the controls provided insurance against the consequences of possible further disturbances. They created a breathing space for making needed reforms, and the authorities made good use of this time, stabilizing the financial system and pushing ahead with regulatory and supervisory reform for the financial sector and capital markets - a prerequisite for fully liberalizing the capital account. Malaysia incurred a cost: an additional 300 basis point spread paid on floating rate debt for a period after the controls were instituted. But the exit strategy has so far not resulted in lasting flight of portfolio capital. Foreign direct investment remains below pre-crisis levels, but it is not possible at this stage to attribute this to the effect of controls. On balance, it appears that both the benefits from and the costs of the controls have been modest, (World Bank Report, 2000).

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The crisis in Thailand and in the Czech Republic have served as a reminder of how quickly international financial markets respond to perceived policy uncertainties and structural weaknesses, and the willingness of market participants to “test” the authorities’ ex-change rate commitment when weaknesses in policies are perceived (IMF, 1997). A fundamental challenge in designing a well-functioning capital market design is to overcome the adverse selection and moral hazard problems between managers and investors, and between generations of investors. Financial disclosure regulations and a complex network of intermediaries, such as corporate boards, auditors, financial analysts, banks, investment banks, and fund managers, are created to mitigate these problems. An embedded assumption is that these intermediaries themselves do not face serious governance problem (Healy and Palepo, 2002). Asia's developing countries have to work out long-term financial sector development strategies that can prevent financial crises as well as lay a stronger foundation for sustainable development. Critical here is the need to deepen and modernize capital markets, particularly bond markets. This need is underscored by the ongoing bank disintermediation, due to extremely guarded lending by both domestic and foreign banks in the aftermath of the crisis. Massive strides in information technology and economic and financial globalization also impel development of financial markets (ADB, 1995).

31

DMCs need to diversify the sources of industrial financing through capital markets. They need to modernize their method of corporate financing, which has traditionally been overwhelmingly bank-based. Effective capital markets can help deepen the financial base, lead to greater diversification of financing sources, and screen financial risks more promptly than bank credit departments (ADB, 1995). The capital market reforms are an integral component of the structural reforms being supported by the International Monetary Fund to restore macroeconomic stability and to build up the banking system, while developing a more conducive incentive regime for industry. The ADB program builds on this (ADB, 1997). These reforms will promote the long-term development of the domestic capital market to enhance the country's ability to mobilize internal and external resources to finance economic growth. It will also help improve the efficiency of allocating resources by increasing reliance on market mechanisms. By promoting a more balanced market structure, the reforms support self-sustaining growth in the sector, with investors and issuers having equal access to the market. Various reforms vis-a-vis the development of capital market will be addressed. These include the establishment of a framework for an integrated national market system; modernization of the underlying support infrastructure; further liberalization of the market by eliminating remaining impediments to market growth; enhancing competition; and strengthening market regulation and supervision (ADB, 1995).

32

The ADB has made enormous efforts to strengthen and modernize financial sectors. Since as early as 1985, the ADB has been involved in comprehensive capital market development work in Bangladesh, India, Pakistan, and Philippines. These programs have aimed to strengthen equity markets, corporate bond markets, asset-backed securities markets, mutual fund industries, investment banks, venture capital companies, and institutional investors, through both public and private sector windows. The ADB is currently helping to develop long-term debt markets in India and Thailand with a focus on increasing the participation of pension funds, insurance companies and mutual fund industries, and also on asset securitization (ADB, 1996). In the wake of the financial crisis, Indonesia, the Republic of Korea, and Thailand were provided with substantial assistance to help restructure their financial and corporate sectors as well as restore the public's confidence in their financial markets. These assistance programs helped the countries to adopt best financial governance practices, increase the disclosure and transparency of financial information, and reform the legal and regulatory framework governing corporate and financial sectors. Capital market development is a key element of all these reform programs. ADB believes that these programs and other assistance activities have significantly contributed to the stabilization of financial and foreign exchange markets, the restructuring of capital markets and banking sectors, and the ongoing economic recovery (ADB, 1995). The reform program by ADB addresses the constraints to the stock market by making the Securities and Exchange Commission an independent and credible watchdog, 33

by developing stronger market regulations and by bringing in modern systems such as an automated central depository system and automated trading systems to integrate the stock markets. The program also expands the limited number of securities by encouraging divestment of government holdings in companies and privatization of state enterprises and by establishing financial intermediaries to develop private debt and equity securities. Institutional sources of capital will also be developed by liberalizing investments of savings institutions, insurance companies, and pension and provident funds and by opening up merchant banking and mutual fund operations to the private sector (ADB, 1997). The Financial Markets and Governance Program (FMGP) at ADB, seeks to support poverty reduction indirectly by facilitating growth and employment creation as well as social protection. The immediate objective of the Program is to (i) strengthen market soundness, stability and investor confidence through improved governance, transparency and risk management; (ii) improved availability of and access to financial instruments for savings and investment and related services; (iii) improve market efficiency and attractiveness to issuers and investors, including institutional and foreign investors. In the context of this program, non-bank financial markets will cover equity markets, debt and money markets, contractual savings, and other non-bank financial institutions and services including insurance, leasing and DFI reform (ADB, 2000). Countries like India, Bangladesh and SriLanka, have also addressed key issues concerning the growth and sustained development of the capital markets in the context of 34

the reforms introduced by the markets regulators and the Government. Introduction of Capital Market Reforms aiming for stronger and vibrant markets, the structural and conceptual factors that influence capital markets are usually taken into consideration. The emerging challenges in the background of recent process of reforms and imperatives for building a strong and vibrant capital market are reflected upon (Financial Daily, 2001). The Reform program in India is promoting the long-term development of the domestic capital market to enhance the country's ability to mobilize internal and external resources to finance economic growth. It also helps improve the efficiency of allocating resources by increasing reliance on market mechanisms. By promoting a more balanced market structure, the Program supports self-sustaining growth in the sector, with investors and issuers having equal access to the market (ADB, 1995). Recent development projects by the Asian Development bank aim to address deficiencies in the Indian and other Asian capital markets and support continuing reforms. Among others: (i) define the options for regional stock exchanges in the context of the emergent environment; (ii) examine whether alternative exchange platforms such as Euro next would be a viable option in the Indian context, (iii) examine the recommendations of the progress report and its impact on the role/operations of the regional exchanges, (iv) examine whether the regional exchanges could undertake new activities such as commodities trading, (v) define the process by which demutualization could be efficiently implemented under proposed legislation, (vi) mitigate risks in the

35

introduction and trading of various forms of derivatives in the Indian market (ADB, 2003). India is now fast moving towards being the benchmark in the international arena in capital markets because of its several far-reaching reforms. The markets are monitored daily on real time basis, which is not in existence even in developed markets, including the US and UK, where it is monitored twice or thrice a day. Many stupendous reforms have been taken, including dematerialization, investor protection norms, move toward T+2 settlement and CLA (Central Listing Authority), for which the notification would be issued soon (Business Standard News, 2003).the capital market development in India is evident from the following table:

36

Table 2.1 NEW CAPITAL (PUBLIC & RIGHTS) ISSUES & INVESTMENT MADE BY FOREIGN INSTITUTIONAL INVESTORS (FIIs) Net Investment of FIIs New Capital Issues Amount

Year

(At monthly exchange rate)

No. Of

Raised

Amount

Issues

(Rs.Mn)

(US $ Mn.)

1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03*

1016 1143 1692 1725 882 111 58 93 151 35 22

186906 243720 27635 208037 142760 45700 55865 78168 61078 75431 32859

4 1634 1528 2036 2432 1649 -386 2339 2160 1846 360

*April-February 2002-03

Source: Securities and Exchange Board of India

The CMDP implemented in Bangladesh spanned over three years, and aimed to create a policy environment conducive to the orderly growth of the domestic capital market and help establish the institutional infrastructure necessary to sustain the capital market’s long-term development. Low savings and investment rates were restricting economic growth in Bangladesh. Banks could provide only limited funds and capital was needed from other sources to get the economy moving. Stock market growth was 37

hampered by a weak regulatory framework, ineffective supervision and a lack of accountability. The Ministry of Finance is the executing agency responsible for creating a broad-based, competitive, efficient and stable financial system fosters investor confidence and encourages savings and investment (ADB, 1997). Pakistan also needs to develop its securities market to enhance resource allocation and to broaden and deepen the financial sector while at the same time providing alternative funding sources to industry, which has had to rely on Government-directed credit. The stock market has been hampered by weak infrastructure and regulatory restrictions on institutional investors who are required to invest a large proportion of their funds in Government securities. Key market participants such as mutual funds, insurance industry and leasing companies are prevented from playing a full role in the capital market by constraints such as tax anomalies, a predominance of the public sector and regulatory weaknesses. The CMDP aims at a fairer, more efficient and regulated system with fewer regulatory and tax constraints. The broad-ranging reforms are expected to stimulate savings and investment and have a positive impact on economic growth, job creation and real incomes. Other measures supported by the CMDP include upgrading automated trading systems to pave the way for an integrated national market. The program will also develop the corporate debt market and the mutual funds, insurance and leasing industries, all of which will benefit from the elimination of discriminatory policy, regulatory and tax regimes (ADB, 1997).

38

The capital market in Pakistan has been undergoing a major restructuring program. This includes establishment of a Securities Exchange Commission of Pakistan (SECP), Central Depository Company (CDC), automation of trade at three stock exchanges and credit rating agencies. A number of measures have been taken to liberalize investment procedures encourage capital formation through stock exchanges; enlarge depth and size of the stock markets. Still a lot more has to be done to ensure transparency and make the market efficient (Kazmi, 2000). .

These days Reforms are the order of the day in most of the developing countries

of Asia because they assist in:  Improving the fiscal, interest rate and investment policy environment, such as rationalizing taxes for financial instruments and investors, providing incentives to stimulate long-term savings, and removing distortions in securities investment criteria and foreign exchange transfer for insurance. 

Boosting investor confidence, through increased transparency and better governance standards, and strengthening of the regulator's enforcement capacity.

 Increasing the supply of financial instruments and bolstering market infrastructure through establishing a separate counter for newly listed and smaller companies, reform of the stock exchanges, further upgrading of trading, clearing and settlement systems, introducing a system of market making for debt and equity, and developing regulations for the issuance of commercial paper and financial hedging instruments. 39

 Developing contractual savings to encourage private sector participation through institutional investment. This includes improving asset management for pensions and life insurance, developing a framework for private pensions and encouraging mutual funds to tap into retail investment.  Improving governance and soundness of operations of non-bank financial institutions through increased private sector participation, improved risk management standards and consolidation to fewer but stronger institutions. (ADB, 2002) Governments have been ineffective in addressing weaknesses of the capital markets. They tried to do too much, dictating resource allocation of financial institutions and bailing out inefficient and virtually bankrupt banks, financial institutions and stateowned enterprises. ADB has proposed a disclosure-based and market-based philosophy of market regulation. This would transform market participants from reluctant to willing partners as far as compliance and disclosure of information are concerned. Under this approach, instead of government regulators imposing value judgments, market participants would have the incentive to comply for their own protection. Market regulators would not have to waste limited resources on evaluations because these could be carried out by market participants through full disclosure. This same approach can improve corporate governance because too much government is blamed for poor corporate governance (ADB, 2000).

40

Two issues should be focused upon in terms of improving the environment of the capital markets. One of them is investor education. A lot that needs to be done in terms of actually improving the level of awareness of the average investor in terms of what it is that they are actually getting into, when they invest in the securities market. In fact, in larger economies too, investors are not very aware of the consequences of their choices. Enron is a classic example. Their own employees had absolutely no idea what they were doing when they were buying Enron shares with their retirement money. So, the least that can be done is to educate the investors. The second is the ability to enforce the laws made to ensure the efficient working of the capital markets. You may have the best laws in the world, but an inability to enforce them is potentially a bigger problem than the macro economic or micro economic reforms. If market participants feel that they can get away with breaking laws, then the sort of capital market countries are aiming to have, will not be possible (Healy and Palepo, 2002).

41

RESEARCH METHODOLOGY 3.1 TYPE OF STUDY The research studies the reforms introduced by ADB for the development of the capital market in Pakistan. It is a descriptive study since the researcher is describing the situation that led to the reforms being introduced, their implementation and its effect and the future of these reforms. No primary research was carried out and all the data was gathered from secondary sources, so it is a secondary research.

3.2 RESEARCH DATA The information for conducting this research study was collected from secondary sources like magazines like Pakistan & Gulf Economist, Finance and Market Magazine and monthly Management Accountant; newspapers such as Dawn, The News, The Nation, Pakistan Times and Business Recorder; research journals like Harvard Business Review, The Pakistan Development Review and Journal of Asian Economics; news releases from Agencies like Asian Development Bank and World Bank; Annual Reports of Securities Exchange Commission of Pakistan, Karachi Stock Exchange and State Bank of Pakistan and from research papers conducted by staff teams of International Monetary Fund and World Bank.

42

INTERPRETATION &ANALYSIS OF DATA 4.1 THE PRE- REFORM ERA In the Pre- Reform Era, the securities market in Pakistan was characterized by the limited equity of established, reputed and well-managed companies. Almost all financial institutions in Pakistan were involved in the securities business. Despite the active participation of institutions such as Nationalized Commercial Banks (NCB), Investment Corporation of Pakistan (ICP), National Investment Trust (NIT), newly created investment banks, and Development Finance Institutions (DFIs), the equity market in Pakistan remained small. Since the corporate sector was relying more on DFIs for their financing needs, this did not allow equity market to develop significantly. This was a policy-induced outcome as most of the DFIs were in the public sector and were providing long-term finance at concessionary rates. Some other reasons for under-development were:



Cost: Cost of equity was significantly higher than debt as dividends were

paid out of after-tax profits while interest on loans, invariably subsidized, was tax deductible. 

Lack of depth: Non-presence of a large number of buyers and sellers

willing to buy/sell at prices above/below the prevalent levels, led to concentration of holdings, which resulted in illiquidity and failure of stock prices to reflect the intrinsic value of the company.

43



Lack of breadth: Pakistan's limited industrial base reduces the choices

available. The herd mentality in establishing industries resulted in over-capacity of different sectors. The financial sector was affected with high percentage of non-performing assets and defaults in an environment where borrowers' quality, financial health, management efficiency and ability to repay was increasingly suspect. 

Crowding out effect: Heavy government borrowing to finance successive

budget deficits had severely limited the availability of credit to the private sector for capital market investments. Even the pension funds, by law, were restricted primarily to government securities only. 

Low equity base of companies: The equity base in Pakistani companies

had been very low ranging between 25% and 30% of the assets. The management of profitable family owned entities avoided going public and share the benefits with the general public as well as open its operations to greater transparency that listing on the stock exchanges requires. 

Pricing of equities: Until 1993, the Karachi Stock Exchange did not allow

shares of new companies to be issued at a premium. Even when this was allowed, the criteria to justify issuance of shares at a premium, failed to prevent unfair practices. 

Lack of investor confidence: The degree of informational efficiency at

KSE used to be relatively low and thus insiders played a greater role. The general investors were deprived of a level playing field. 44



Financial disclosure by companies:

Listing involved obligation to

disclose information, which the companies preferred to avoid. There was an acute dearth of timely and accurate financial information. The lack of details in the annual reports considerably reduced the usefulness of the disclosure.



Protection of minority interest: The dividend payouts by listed

companies in Pakistan remained very low, which was a cause of concern for minority shareholders. Pakistan’s equity market has been underdeveloped for many years. It was in the backdrop of heavy speculative trading, negligence in implementing exposures and loss regulation, irregularities in appointment of directors and mismanagement of funds, late filing of accounts and non- holding of annual general meeting that a growing need to discipline the market was felt. Time had come to impose strict risk management measures, review the existing rules and eliminate unhealthy trading practices and bring about changes for organized and smooth working of stock markets. Table 4.1

PERFORMANCE OF KSE IN THE PRE- REFORM ERA (Amount in Billions of Rs)

Source: State Bank Annual Report, 2002

45

In recent years, the government increasingly came to realize the importance of improving the efficiency of the securities market and its relevance to private sector development and economic growth. In the context of Pakistan, securities market has a special significance, as equity instruments are the truest form of riba-free investment besides achieving socio-economic objective of imparting a sense of participation to the general public in the prosperity and development of the country.

4.2 OBJECTIVES OF THE CAPITAL MARKET DEVELOPMENT PROGRAM The development of a secondary market depends on a variety of factors, including capability and skills of dealers in market making, privileges provided by the central bank that allow dealers to carry out their obligations, quality of the payment system in terms of efficiency and ease, spectrum of alternative government and non-government debt instruments available to investors, and saving behavior of economic units in the country. For rapid development of the capital market, Government of Pakistan took a number of policy decisions, which have gone a long way in revamping the overall structure of the stock market and seek to create a conducive investment friendly environment. The Government’s top priority at the time of program formulation in early 1997 was to restore political and economic stability in the country. It requested ADB assistance in capital market reforms to augment and complement such activities. Reforms of the securities markets, encompassing both primary and secondary markets, were aimed to improve the prospects for issuers to mobilize long-term resources and provide 46

alternative opportunities to suit their preferences, to create a higher degree of credibility and competition in the industry and to minimize business risk. To achieve these objectives, the regulatory and institutional frameworks were to be strengthened to improve investor confidence, market distortions eliminated, the securities market infrastructure modernized and upgraded, investment alternatives improved, and the efficiency of market participants enhanced. The Capital Market Development Program initiated by ADB, aimed to augment the mobilization of long-term resources and improve the efficiency of their allocation through a diversified and competitive capital market, which encouraged broad-based participation of issuers and investors. The Program covered seven key areas, in support of developing the capital market: 

Creating a policy environment to enhance competition, and a level playing

field 

Strengthening governance, institutions, regulations, and supervision of the

securities market 

Improving and modernizing securities market infrastructure and its

integration 

Developing the corporate debt market



Introducing reforms in the mutual fund industry



Developing the leasing industry

47



Promoting contractual savings through reforms of the insurance sector and

pension and provident funds. Detailed list of reforms is attached in Appendix 1

4.3 CAPITAL PAKISTAN

MARKET

DEVELOPMENTS

IN

The capital market in Pakistan has been witnessing steady progress and structural developments in both its institutional set-up and operational matters since the early 1990s. Credible maturity has been achieved in the working of the capital market despite some adverse domestic and international shocks in the last few years. The present Government not only continued the market oriented development strategy of the 1990s but also added some new impetus to improve the working and depth of capital market in Pakistan. Along with domestic investors, foreigners and overseas Pakistanis are now also offered every possible incentive and opportunity to undertake investment in projects of their choice. The first phase of ongoing reforms in the capital market initiated by the ADB have been completed. ADB expressed its satisfaction over the implementation of the first phase of reforms of the capital market and has recently approved an integrated assistance package of three loans and two political risk guarantee facilities, under the Financial Markets Governance Program (FMGP) for initiating the second phase of capital market reforms in Pakistan.

48

The successful completion of the first phase of reforms left a healthy impact on the working of the capital market, which has now become more efficient, reliable and transparent. This improvement was noted both within and outside the country. The second phase of reforms builds on to the earlier improvements, and is largely developmental in nature. These reforms will have the effect of bringing Pakistani markets in line with best international practices. After recording impressive performance in 2001-02 the KSE-100 index resumed its upward movement in 2003. Pakistan’s stock markets have remained buoyant during 2002- 2003, with the KSE- 100 witnessed a phenomenal growth to an all time magic high figure of 3900 points in July, 2003 and the market capitalization of the exchange now stands above $15 billion. This milestone was achieved because of the government’s macro economic policies, strengthened macro- economic indicators, and the confidence of both local and foreign investors’ on the country’s economic policy and on the KSE. Yet another indicator of impressive performance of the Karachi Stock Exchange has been an extraordinary surge in monthly turnover of shares from 2.4 billion in 2001-02 to 4.0 billion during July-April of 2002-03. The average daily turnover of shares has increased from 74.3 million in 2001-02 to 104.7 million in the first two quarters of 2002-03 and further to 243.1 million shares in the third quarter of 2002-03. Bullish business trends are also being witnessed during the years at the other two stock exchanges namely, the Lahore and Islamabad Stock Exchanges. The ISE started functioning in August 1992 and within ten years it has developed into a vibrant, efficient and stable market. Today, the 49

ISE is one of the premiers Stock Exchanges of the country known for the highest standard for transparency in its operations, excellent risk management, dynamic market technology and lowest overall costs of listing.

Table 4.2

PROFILE OF THE STOCK EXCHANGES IN PAKISTAN

KARACHI STOCK EXCHANGE

19992000

2000-01

2001-02

a)

New Companies Listed

1

4

4

2002-03 * April 2003. (July-March) 1

b)

Fund Mobilized (Rs Billion) Listed Capital (Rs Billion) Turnover of Share (Billion No) Average daily Turnover of Share (in million) Aggregate Market Capitalisation (Rs Billion)

8.9

3.6

15.2

23.1

236.4

235.7

291.2

299.3*

48.1

29.2

29.1

36.2

202.1

122.5

158.6

243.4

392

339.2

407.6

637.0*

19992000

2000-01

2001-02

2002-03

c) d) e) f)

LAHORE STOCK

2

3

3

(July-March) 2

0.4

2.5

14.2

1.7

207.7

226.2

246.3

282.7

16.4

7.8

18.3

19.5

372.0

273.5

297.5

496.6

365.9

325.7

393.3

595.8

EXCHANGE a)

New Companies Listed

b)

Fund Mobilized (Rs Billion) Listed Capital (Rs Billion) Turnover of Share (Billion Nos) LSE Index

c) d) e) f)

Market capitalization (Rs Billion)

50

ISLAMABAD STOCK EXCHANGE

19992000

a)

New Companies Listed

0

b)

Fund Mobilized (Rs billion) Listed Capital (Rs billion) Turnover of Share (In Billion Nos) ISE Index

c) d) e)

2000-01

2001-02

2002-03

5

1

(July-March) 0

0

0.8

3.7

0

-

183.3

183.4

228.2

3.1

1.4

1.70

1.3

5327.2

4374.2

4684.0

5924.5

All the 12 major trading groups on the KSE (cotton and other textiles, pharmaceuticals & chemicals, engineering, auto & allied, cables and electric goods, sugar and allied, paper and board, cement, fuel and energy, transport and communication, banks and other financial institutions, and miscellaneous) recorded positive growth in their share indices, ranging from 1.7 percent (cement) to 79.8 percent (auto & allied). This performance, which appears to be underpinned by a steady improvement in economic fundamentals during the course the year, is more impressive when viewed the context of the various economic and non economic shocks suffered by the country, as well as a number of disruptive market developments. Table 4.3

KEY INDICATORS OF CAPITAL MARKET

51

Source: State Bank Annual Report, 2002

Pakistan has now a capital market with high degree of integrity and transparency in terms of price discovery and trade settlement. The observance of enhanced accounting standards, reliable audits, institutional strengthening and capacity building of the Securities & Exchange Commission of Pakistan (SECP) have been the hallmark of the capital market reform program. Pakistan is today largely compliant with International Organization of Securities Commission’s (IOSCO) 30 principles of securities regulation. The market friendly measures introduced during the last four and a half years had a significant impact on investor confidence and the stock market is no longer viewed as attracting only die- hard speculators. The structural changes brought about by the government have been quite successful in restoring investors’ confidence in the equity market. The market has clearly attracted genuine investment as is evident from the fact that actual settlement has risen from about 1 to 2 percent of trades in the early part of year 2000 to around 10 to 15 percent by June 2003. Although equity issues have 52

not picked up, there has been a significant increase in debt capital issues, the aggregate amount of new capital listed in the last two years being as much as Rs 30 billion etc.

Figure 4.1

GROWTH IN THE TFC MARKET

In Pakistan, the Karachi stock exchange is playing a central and critical role in shaping the savings and investment climate, as it is the main window to ensure that the market continues to grow and generate interest of investors both within the country and abroad.

53

Table 4.4 PROFILE OF KARACHI STOCK EXCHANGE DURING THE REFORM PERIOD

54

Till the fifth year of implementation of reforms i.e. 2003, many developmental steps have been taken regarding various aspects of the capital markets to ensure compliance with the ADB’s proposed reforms and to enhance market efficiency and investor confidence. The important initiatives in this regard are highlighted below.

4.3.1

Privatization Of State -Owned Enterprises:

Privatization has again been revived, with emphasis on phasing the process through domestic listing of public sector entities on the local stock exchanges initially. This is to be followed by induction of professional management and only then inviting strategic investors at the international level.

55

The government of Pakistan is firmly committed to privatization because it expects to enhance the quality of goods and services, strengthen the fiscal position, broaden and deepen the capital markets and reduce opportunities for corruption. The government is working to improve liquidity. Under the new privatization strategy, it's selling off its shares of state-controlled companies while listing them on the bourse as well. This government policy to sell its share in large State-Owned Enterprises (SOEs) through stock exchanges was of great significance in development of the equity market. Increased supply of securities such as the Pakistan Telecommunication Corporation (PTC) and the Muslim Commercial Bank (MCB), and the large issue of a power project, namely the Hub Power Company (HUBCO), which has been actively traded, have considerably increased the market depth. In last four months, about $70 million worth of stock in three state-owned companies has been sold, and more is expected to follow. For instance, two state-owned energy companies, Pakistan Petroleum Limited, and Pakistan Oil & Gas Development Corp. are expected to be listed by the end of 2003.

4.3.2

Securities Exchange Commission Of Pakistan: In the past, the Corporate Law Authority (CLA), which was a subordinate department of the Ministry of Finance (MOF), was responsible for the regulation of the capital markets. The policies of liberalization implemented in the l990's led to rapid expansion in Pakistan's Capital Markets which called for a more professional approach for regulation. On the supervisory front, CLA’s control over capital market was 56

compromised due to lack of autonomy and overlapping of some functions with Monopoly Control Authority and Controller of Capital Issue. In addition, inadequate professional capacity restricted these agencies to exercise their supervisory functions effectively. On the other side, stock exchanges lacked proper infrastructure for trading and settlement. A well-equipped regulator conforming to international standard with adequate capacity to monitor the market was needed and this need for regulation was also expressed by the ADB. This long over-due process started in January 1999 when an autonomous Securities and Exchange Commission was set up to replace the Corporate Law Authority (CLA), which could not possibly meet the new challenges arising out of the dynamic market development. The Commission became financially autonomous in July 1999 - six months after its establishment. SECP was established as the chief regulator of the stock exchanges and was entrusted with the task of initiating reforms to improve the working of the stock exchanges. The SECP’s role was further enhanced when it was assigned regulatory responsibility for the insurance industry, and private pension schemes and other non-bank financial institutions (NBFIs) i.e. leasing, housing, and investment banks in 1999 and 2000 respectively. 4.3.2.1 Functions: The main functions of the Securities and Exchange Commission of Pakistan according to the SECP Act are:

57



Maintain facilities and improve performance of companies and securities

markets. 

Maintain the confidence of investors in securities markets by ensuring

adequate protection.



Achieve uniformity in performance of functions and exercise of powers.



Administer laws effectively with minimum procedural requirements.



Receive, process and store, efficiently and quickly, the documents lodged

with and information filed with. 

Ensure that documents and information filed with the commission are

accessible to the public. 4.3.2.2 Superiority over CLA: The main advantages of the Securities and Exchange Commission of Pakistan over the Corporate Law Authority are:



As compared to the CLA that needed the approval of the Ministry of

Finance before taking action, the Securities Exchange Commission of Pakistan is an announced body. 

The commission has been granted the power to take action on its own

initiative without having to wait for a complaint to be filed. 

The conclusion of three representatives of the public (2 chartered

accountants and an investment banker), in the 5 commissioners of the Securities 58

and Exchange Commission of Pakistan has greatly increased transparency and seek to ensure greater protection of the rights of general investors. Thus, the regulation and governance of Pakistan's financial market and corporate sector has been substantially strengthened with the commencement of operations of the SECP in 1999. The initiatives taken by the SECP are aimed towards ensuring that the exchanges conduct themselves as a national institution, fully protecting the interest of investors, who are the major stakeholders in the system. Over time, the Commission, as a regulator, has been entirely transformed through the implementation of a drastic restructuring program that was largely completed during 2001-2002. The institutional capacity was strengthened through appropriate reorganization, staffing, training and automation. The Commission now has reasonably well-functioning units that keep the market under surveillance, enforce the law it administers, closely monitor and try to foster the various specialized institutions it regulates, and keep vigil to ensure that the various activities under the ambit of the Commission are performed effectively and efficiently. While there is considerable ground that is yet to be covered, it is felt that in many respects the Commission is approaching International standards in the discharge of its regulatory responsibilities. 4.3.2.3 Monitoring & Surveillance: Since it became operational, SECP has implemented many laws for the betterment of capital market. Although stock exchanges in Pakistan are mostly self-regulating authorities, SECP is actively monitoring their activities and making amendments in regulations to create a level playing field for all 59

investors. The SECP has set up a Monitoring and Surveillance Wing. The Surveillance Wing carries out on line monitoring of the stock exchange to effectively monitor the activities at the exchange and to take corrective measures as and when needed. 4.3.2.4 Enforcement Division: The SECP has already created an Enforcement Division under a full-fledged Commissioner who is monitoring the performance of listed companies. The SECP has a plan to strengthen its investigative unit by induction of properly qualified and trained staff for such purpose A solid foundation has been laid by the Commission to ensure healthy growth of the capital market. It is continuously engaged in efforts to strengthen the integrity and efficiency of the capital market so that the investors develop a sense of confidence in its operation.

4.3.3

Central Depository Company (CDC): Another noteworthy step in the reform process was the creation of the Central Depository Company of Pakistan Limited (CDC) in 1993 to facilitate electronic transfer of stocks. The CDC commenced its operations in September 1997. This depository company was established by stock exchanges in collaboration with the International Finance Corporation (IFC), Citibank, leading commercial banks and DFIs. This greatly encouraged market activity and streamlined the settlement process. The central

60

depository was one of the most vocal demands of foreign investors and with its setup there has been a manifold increase in trading on the exchange. The affect of CDC on the workings of equities market is tremendous. In fact, CDC has revolutionized the settlement procedures of stock exchanges completely. It has not only reduced the cost of processing transactions for investors as well as Central Depository System (CDS) elements, it has also brought extraordinary efficiency and transparency in security transactions which was desperately required to restore the investors (both local and foreign) confidence. This change has brought the Pakistani market at par with rest of the world. 4.3.3.1 Services provided by CDC: CDC provides the following facilities: 

Eliminating paper settlement along with the problems associated with it

like fake/stolen/lost share certificates etc. 

Settlement through CDS is electronic; the transfer of ownership is

instantaneous (which previously used to take 45 days). 

It does not attract stamp duty reducing the cost of investors.



Delivery versus Payment Facility (DVP): DVP is the international

settlement standard which involves the simultaneous and irrevocable exchange of cash and securities. A safe and efficient settlement system, which is a bilateral transaction between two Account Holders/Participants in which funds and securities are transferred from one account to another electronically. Previously, there used to be a small timing difference between release of securities and 61

payment, which increased default risk by either party. DVP reduces the settlement risk through simultaneous exchange of securities and funds. In DVP, the CDC maintains a central cash and securities' account for all participants and undertakes a trade only when sufficient balance exists in both parties' accounts. Since DVP is the international standard, this has given a tremendous boost to the foreign investors and further improved their confidence in the local market. 

Investor Account Services: Allows investors to directly open and

maintain accounts in Central Depository System for electronic settlement of securities. Earlier, to settle the securities through Central Depository System, investors had to open client accounts (sub accounts) or group accounts with the Participants (brokers; financial institutions). Now, with Investor Account Services, investors can also have direct access to CDC. CDC is not a profit maximizing organization. Its focus is more on helping the equities market to become more efficient and transparent then to generate revenues and its track record is a witness to its claim. CDC has reduced its charges significantly since becoming operational and it will continue to do so in future as well. Its aim is to generate enough revenue to keep running and to keep some for future growth. As and if it makes more, it will reduce its charges. CDC is also considering asking the State Bank of Pakistan (SBP) to give approval to make government securities scripless and have all of them listed in its system. The SBP has given the CDC permission to start work on this project - the anticipated time 62

being around 12-18 months. While trading would be delegated to the CDC, overall control of these government securities will remain with the SBP. Such a move will not only help automate the government paper dealing, it will also provide a central forum for trades in all kinds of money market and capital instruments. For further improvement of market infrastructure and ensure efficient trading, all listed companies are being motivated to enter the central depository system. CDC is now an integral part of the stock market in Pakistan and has completed five and a half years of its operations. In the past, the KSE had been relatively looked down upon in the regional markets due to its technological and operational backwardness. However, with these recent developments, this perception has changed. In fact, the capital market reforms of the ADB have already gone a long way towards introducing professionalism and innovation in the market. Most of these reforms are heavily IT based and follow on the patterns of the more developed exchanges.

4.3.4 Opening Foreigners:

Of

Capital

Market

To

Exchange reforms proved to be of great significance in the development of capital market. Through these reforms, foreigners and oversees Pakistanis were allowed to make investments without prior approval except in few specified industries. This resulted in large inflows of foreign funds. Furthermore, the permission to retain 100 percent equity by foreign investors in a company with no obligation to go public helped improve their 63

confidence in Pakistani markets. Other important steps in this regard were: the permission to bring in any amount of foreign currency and to take it out freely; treatment of foreign private investment with regard to taxes on income, at par with those applicable to similar investment made by citizens of Pakistan; and relief from double taxation in cases of those countries with which Pakistan had treaties for avoidance of double taxation

4.3.5

Automated Trading: During the 1990s, in the pre- reform era, trading was carried out through open outcry system. Due to lack of automation, turnover remained very low, and in the absence of a depository company, investors had to take physical delivery of shares. The SECP has designed a system for Internet trading along with a regulatory framework. All three stock exchanges moved to fully computerized trading by mid-1998. In the KSE, it is known as KATS (Karachi Automated Trading Screen), which has completely abolished the open outcry system. Necessary amendments in the existing software at the three stock exchanges regarding automated trading have been made. The automated trading system has also made transactions transparent and easier to execute.

4.3.6

Risk Management Measures: After the crisis of May 2000, SECP took up the question of strengthening risk management with the management of all three stock exchanges. 4.3.6.1 Regulations for short selling: Short selling has been prohibited by the SECP and it has also been restrained from inter-settlement carry over. All outstanding trades are 64

required to be settled and no carry over is allowed unless the possession of shares is evidenced. This action would prevent volatility in price fluctuation; and stabilize the market. This restriction was extended to all listed companies on December 4, 2000. In an effort to regulate short selling in the ready market and to bring it in line with international best practice, the Commission approved the Regulations for Short Selling under Ready Market, 2002 in February 2002. Introduction of these Regulations is a significant step towards minimizing market manipulation and ensuring a healthier and more transparent capital market 4.3.6.2 Transparency in broker dealings: Additional rules governing the broker's code of conduct and disciplinary actions have been introduced and all brokers are required to adhere to them. This ensures an adequate level of transparency in broker actions or dealings as well. It would be worth mentioning that this rule will be quite useful for small investors have can easily be taken for a ride. A recent case of broker pledging securities of his underlying investor (who subsequently lost them when the broker defaulted) can easily be prevented by this rule. 4.3.6.3 Undisclosed Trading System: Another important development in the stock market is the implementation of “Undisclosed Trading System”. On October 7, 2002, the KSE launched this trading system where the identity of the buyers and sellers is not disclosed. This is in accordance with international practice and has helped check manipulation and front running to a certain extent. 65

4.3.6.4 The Investor Protection Fund (IPF) And Clearing House Protection Fund (CHPF): The Investor Protection Fund (IPF) and Clearing House Protection Fund (CHPF) have been set up to ensure effective risk management in the secondary market and to protect investors’ interest in case of default by members of the exchanges. The Commission observed that the funds were not fully funded by the exchanges and directed them to ensure that the IPF and CHPF become fully funded by June 30, 2007. The requirement has been phased-in so that by June 30, 2002, the exchanges would have to fund at least 50 percent of the actual contributions made towards IPF and CHPF. Thereafter, the funding requirements would increase gradually so that by June 30, 2007, both funds would be fully funded. Furthermore, the Commission has also directed that an auditor found guilty of professional misconduct would not be allowed to audit the accounts of listed companies for a period up to three years. It is expected that these measures would go some way to protect the interests of the investors.

4.3.7

Carry-Over Trade (COT) System: In September 2001 and May 2002, the market witnessed abnormal price fluctuations due to the September 11 events and growing cross-border tension between India and Pakistan, respectively. On both occasions, the risk management measures, earlier introduced by the Commission, worked effectively. However, certain weaknesses were observed in the COT system. The volatility of the market also exposed certain shortcomings in the Carry-over Trade system (COT), which prompted both, over trading 66

by weak holders as well as sudden withdrawal of funds by COT financiers. These weaknesses were discussed at length with various stakeholders including brokers, investors and stock exchanges’ management and also deliberated in meetings of the Stock Exchanges Coordination Committee and the Consultative Group for the Capital Market. To ameliorate the situation, the Commission introduced several remedial measures in 2002 that helped in strengthening regulation of the COT market and the stock exchanges were advised to make the following changes in the COT system:



COT should be for a minimum period of 10 days with the financee having

the option to release it after one day 

COT should only be allowed in specified liquid shares



Higher margins should be mandated for COT



COT shares should be kept with the CDC or with the clearinghouse of the

stock exchange and should be pledged in the name of the financier, if the financier were a bank or a financial institution. The carry-over market movement closely paralleled that of the ready market. Between September 2001 and June 2002, the daily traded value in COT averaged Rs. 3.5 billion with a low of Rs. 0.03 billion on July 13, 2001 and a high of Rs. 11.5 billion on February 8, 2002. Figure 4.3

TRADED VALUE IN READY & CARRY-OVER MARKET (JULY2001-JUNE 2002)

67

Source: SECP Annual Report, 2002

4.3.8 Regulation Of Brokers: In order to bring transparency in the business of stock market, brokerage houses and members (broker/dealer) a proper system of inspection of books and records of such brokerage houses/brokers is being established. The regulation framed comprehensively, lists out documents/records, which the brokerage house/brokers would be obligated to present for inspection to a person authorized by the Commission for the said purpose. The basic aim of these regulations is to ensure fair dealing, proper documentation etc. Failure to comply with the regulations would entail penal action.

68

The Commission promulgated the Brokers and Agents Registration Rules in May 2001 to establish a direct regulatory nexus with brokers and agents for protection of investors’ interest. No person can act as a broker or agent to deal with transactions in the securities market, unless registered with the Commission. The registration of brokers and agents under the Brokers and Agents Registration Rules 2001 started on November 1, 2001. These regulations enable direct controlling of brokerage activities. It allows smooth operation of stock market and serves as a tool for investor protection. The statistics with respect to registrations granted up to June 30, 2002 are presented in the table below.

Table 4.5

REGISTRATION OF BROKERS &AGENTS

Source: ADB Report, 2002

Registration of brokers and agents has had a positive impact on stock market dealings owing to the enhanced level of awareness created amongst brokers and agents regarding the level of integrity and care required of them in the conduct of their business. 69

4.3.9

T+3 Settlement System:

In order to reduce systematic risk in the stock market, the “Group of 30” recommendation called for the utilization of rolling settlement on a minimum of T+3 basis (trading date plus three days). In T+3 settlement system, the purchase and sale transaction must be delivered and settled on the third day following the date of trade. In the past, the stock exchanges in Pakistan had been following fixed trading settlement system. The trading was carried out for fixed period normally from Friday to Friday to be settled the following Wednesday. The Exchanges clearing house thus carried the settlement risk for about ten days. At times the period was even longer than ten days due to holidays or some other reason. It was particularly high in case of our stock exchanges, which were relatively illiquid and could be manipulated easily. In the past, many defaults by members occurred due to over exposure of members on account of this longer clearing cycle. The weekly settlement system, together with Badla and open window led to huge turnover and mindless speculation. Due to this it became a market where people could buy shares with no money and sell without possessing any shares. The T+3 system is aimed at capping systematic risk and improves efficiency of the settlement process. It has been introduced in order to bring down speculative and overtrading beyond the financial capacity of the brokers thereby risking the investors’ hard earned money.

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4.3.9.1 Benefits: Implementation of T+3 is a significant achievement, which has gone a long way in improving the markets’ efficiency and transparency. The main benefits of T+3 system are:



It reduces risk as the time between execution of trade and settlement of

trade is cut down substantially. 

It helps generate liquidity as the buyer will receive the shares and the

seller will receive the cash earlier i.e. on the third day of trade whereas presently both buyer and seller will receive shares or cash whatever the case maybe, on the 10th day. 

It particularly provides comfort to foreign institutional investors as T+3

settlement system is internationally known and is in line with other major stock exchanges of the world. Under T+3 with CNS facility, all settlement is made with the clearinghouse rather than with a contra-clearing member. The T+3 system with CNS eliminates the possibility of multiple deliveries or receipts on a settlement day. It also permits an additional level of vetting by eliminating the need to actually settle a given day’s transactions on settlement day and carrying the position over to net with the settling trades on the next settlement day. This facility enables the broker to reduce the actual settlement movements thereby reducing the costs.

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The implementation of T+3 first resulted in reduced turnovers at the stock exchanges and people misinterpreted it with faults in the system itself and its inability to complement Pakistan’s equity market structure. However, the low turnovers were due to the lack of understanding, lack of practice, natural resistance to unknown and parallel availability of the old system. There were some minor dislocation in the trading system, but it is now back to be normal since the investors have fully realized its benefits. The implementation of the T+3 system with CNS has gone a long way in bringing the capital market in Pakistan in line with international standards and has greatly helped in restoring invertors’ confidence particularly of foreign investors who feel more comfortable with international standards.

4.3.10 Capital Adequacy Requirement: The SECP has implemented capital adequacy for stockbrokers. Previously, the KSE allowed brokers to carry an exposure of Rs 50 million free of cost. The SECP has come out quite vocally against this and now there is no deposit-free exposure limit and

72

exposure up to Rs 50 million will require a 5 per cent deposit. These deposits are accepted in either cash or securities, as is the current practice. The member would be required to maintain a capital adequacy ratio, which is 25 times of the net working capital. All exposure of the brokers is now subject to margin. Members would now be required to deposit five percent margin against their trade within the exposure limits The net capital balance requirement has been substantially increased to 2.5 million rupees in case of a stock exchange having a turnover of securities exchanging 15 billion shares; Rs 1.5 million in case of turnover of securities exceeding 7.5 billion; and Rs 0.75 million in case of turnover of securities not exceeding 7.5 billion.

4.3.11 Insider Trading: The regulations imposed by SECP aim at curbing trading on the basis of privileged information. The act of dealing in securities of listed companies on the basis of unpublished price sensitive information or communicate any unpublished price sensitive information to any person has been made a culpable offense, carrying fine which may extend to three times the gain accrued or imprisonment for a term which may extend to three years. They go a long way in curbing the curse of insider trading. The Securities and Exchange Commission of Pakistan (SECP) has notified the detailed guideline to be followed by all the stakeholders to check and eliminate insider trading from the stock markets of Pakistan. The commission reserved the right to proceed against those who are found violating these guidelines and involved in any manner in this 73

unethical practice. The detailed instructions titled as “listed companies (prohibition of inside trading) guidelines” have been effective. Insider trading has been banned under the Securities and Exchange Ordinance 1969 and the SECP is empowered under the 1997 act to frame rules and guidelines to enforce this proposed ban. As per guideline an insider means:



A person who is director, chief executive, managing agent, chief

accountant, secretary or auditor of a listed company or the beneficial owner holding directly or indirectly not less than 10% of the shares of a listed company; or 

A person who is or was connected with the company or is deemed to have

connected with the company, and who is reasonably expected to have access, by virtue of such connection, to unpublished price sensitive information in respect of securities who has received or has had access to such unpublished price sensitive information. The guideline provides that no person who is or has been, at any time during the preceding 3 months associated with a listed company shall:



Either on his behalf or on behalf of any other person, deal in securities of a

company listed on a stock exchange on the basis of any unpublished price sensitive information; or

74



Communicate any unpublished price sensitive information to any person,

with or without his request for such information, except as required in the ordinary course of business or under any law; or 

Counsel or procure any other person to deal in securities of any companies

on the basis of unpublished price sensitive information. “Unpublished price sensitive information” in relation to a listed security, as described in the guideline, means any information which relates to the following matters or is of concern, directly or indirectly known to a company and is generally known or published by such company for general information, but which if published or known, is likely to materially effect the price, of securities of that company in the market;



Financial results (both quarterly and annual) of the company.



Intended declaration of dividends (both interim and final).



Issue of shares by way of right, bonus, etc.



Any major expansion plans or execution of new projects.



Amalgamation, mergers, or takeovers.



Disposal of the whole or substantially the whole of the undertaking.



Such other information that may affect the earnings of the company.



Any changes in policies, plans or operations of the company.

According to the SECP guidelines, the penalty for violation of provisions relating to the inside trading for a person who deals in securities or communicate any information 75

or counsel any person dealing in securities in contravention of provisions of previous section shall be guilty of insider trading and shall be liable to penal action under section 15B of the Ordinance. The commission is empowered, to a point, an inquiry officer to investigate and inspect the books of accounts and other relevant record of an insider. The purpose of the commission is undertaking this exercise. To protect small investors from excessive volatility in share prices on the basis of trading driven by privileged information, this law has long been in the offing. It has helped dispel the insider-outsider perception that deterred small investors from approaching the capital markets. If this is effectively implemented, this law should be able to extend the short-term investment horizon that currently dominates the stock markets.

4.3.12 Buy Back Shares: The Companies (Buyback of shares) Rule (1999) is primarily motivated to inject liquidity into those scrips that are not actively traded. Since many of these companies are largely family owned (and controlled), public offerings, when these companies were first floated, were done on compulsion rather than a strategic decision to diversify the capital base of the company. Hence, since these token scrips were first issued to the public, trading was minimal. It has long been discussed that such companies should have the right to buy back these scrips to inject liquidity into the market and to encourage more accurate market valuation. The decision to permit buy back has been allowed on the

76

condition that SECP will carefully monitor such activity to ensure that companies cannot manipulate share prices. The company law amended in response to a move by the KSE to compel the management of such listed companies as had been defaulting on dividend payments to their common shareholders to more than for more than 5 years. The move produced some good results in that most of the companies started payment of dividends but those, which were unable to do, so alternatively offered to buy back their shares from common shareholders intending to sell their holdings. In that case, however the KSE in consultation with the SECP would fix a buy back price. By buying back shares when they are being quoted below break-up value, companies can improve the market price of their shares. Although companies buying back their own shares will be allowed to cancel them, resale of Treasury Stock will not be allowed. In order to avail this facility, companies have to maintain a debt equity ratio of 40:60 and a current ratio of 1:1. In addition, other conditions for a buy back include the passing of a special resolution, a tender and availability of funds from profits available for appropriation. The SECP’s decision to make relaxations in the buy back conditions, was seen as a device to generate buying interest particularly at the juncture when the stock market in the country was desperately looking for buying support so that the downward movement in the equity vales could be halted and stability restored. The interesting aspect is that the 77

latest step provides for a blanket buy back permission for all the registered companies, irrespective of their trade records in respect of payments of dividends regularly. This implies that sponsoring groups of leading companies would now have the scope to increase their holdings in their own companies to any extent contrary to the original provision in Company law making it obligatory upon sponsors to offer a minimum of 50% of their paid-up capital for subscription to general investing public and financial institutions, and then alone their companies would be entitled to be defined as broad based public limited companies in order to get the benefits of corporate tax at lower than the rate applicable in the case of private limited companies. The rules require certification by the auditors as regards the maintenance of financial ratios at prescribed level, maintenance of the debt equity ratio at an ideal level of 60:40 and also about the availability of sufficient cash resources. Obtaining of such certificates not only causes extra financial burden on the companies but also is not convenient to them, therefore the desired results have so far not been realized.

4.3.13 Declaration Of Dividends: A part of the Capital Market reforms is that companies are required to pay dividend at least once every five years. If they do not do so, strict action will be taken against them. After the reforms process was set in, there was a marked increase in the number of companies declaring and paying dividend. Regular inflow of dividend declarations has made a positive impact on the market. The companies declaring

78

dividends in the three stock exchanges in Pakistan have been increasing each successive year. Table 4.6

COMPANIES PAYING DIVIDENDS AT KSE

Source: State Bank Report, 2002

4.3.14 Over-The-Counter (OTC) Market: Among a variety of developmental measures taken by the SECP, approval was granted for establishing, under the aegis of the KSE, the framework of an over-thecounter, quote driven market targeting closely held or smaller capitalized companies as well as debt securities. This would appropriately tier the stock market with trading modalities determined to suit each other. A quote-driven OTC market, essentially for small-cap stocks and debt securities, provides investors with an alternative, convenient and efficient avenue to make investments. Moreover, promoters can set up new projects or expand their 79

operating activities by raising finance in a cost-effective manner in the OTC market where regulatory requirements are less stringent than in case of regular listing. An OTC market provides several benefits to investors and issuers that include the following:  It provides liquidity to illiquid shares.  It is cost effective for issuers.  It affords opportunities to young companies, without a proven track record, to raise risk capital for making productive investment.  It enables access to a wide spectrum of financial intermediaries.  It provides venture capital and private equity funds an exit route for their investments. The proposed minimum capital requirement for a company to be listed on the OTC market is Rs. 10 million as compared to Rs. 50 million for the regular market. The minimum public offering will be Rs. 5 million or 25 percent of the capital whichever is higher. In May 2002, the Commission approved, in principle, the concept of an OTC market and the stock exchanges are currently in the process of drafting the necessary regulations.

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4.3.15 Disclosure Requirements: The Commission has directed all the listed companies to submit their quarterly account in an effort to improve transparency and disclosure by companies. The companies are required to submit these accounts to their registrars and shareholders as well as to the Stock Exchange and the Commission. Maximum disclosure has been ensured in the prospectus for information of prospective investors. The review of prospectus for further improving the quality of disclosure in the prospectus has been initiated. Further disclosure requirements would be prescribed on the basis of recommendations of the consultants under CMDPL. The KSE has also proposed laws seeking disclosure of a party wishing to acquire substantial holding in a company (which would eliminate insider trading). This is quite a notable step by the KSE. Other laws include a corporate takeover law (to wipe off the bad blood in the market) and enhancement of shareholder powers to remove the management.

4.3.16 Accounting Standards: The SECP has notified and prescribed cost accounting records for companies to facilitate audit process. Consultative process with trade and professional bodies has been initiated in respect of quarterly reports to be published by the listed companies. Two new International Accounting Standards have been adopted. The observance of International Accounting Standards (IAS) was enhanced further by the end of 2002, when a total of 38 out of 41 IASs were adopted.

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4.3.17 Employee Stock Options: The Employee Stock option Program (ESOP) has been successfully used by the developed countries to augment productivity/efficiency by motivating their employees through this scheme. Under this scheme the shares are gradually allotted which keep on increasing over a period of time, binding the employees to their companies/corporations with the sense of sharing ownership. In Pakistan this scheme was initially introduced in 1992 and now comprehensive regulations have been framed, which are being introduced. New sets of rules were announced in January 2001, to ensure smooth operations of Employees Stock Options through which it would be ensured that employees are motivated to have greater share in the companies stock.

4.3.18 Corporate Debt Market: There has been a significant expansion in the corporate debt market since 1998 partly due to policy changes in the National Saving Schemes (rationalizing rates and restricting incremental institutional investment) and the launch of the Pakistan Investment Bonds. In addition, the bearish trend in equity markets during 2001 shifted investors toward more secure investments in term finance certificates (TFCs). As against four TFC issues floated in the market before 1998 for PRs 732.37 million ($11.8 million), there were 25 TFC issues mobilizing PRs13, 501 million ($217.8 million) between 1998 and 2001.

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The increasing number of TFC issues shows the interest of the investors in debt instruments as compared to equity issues. TFCs are gaining popularity among investors due to a number of factors:  Attractive and guaranteed return and safety of principal amount invested.  Substantial fall in returns under various National Saving Schemes.  Restrictions imposed on institutional investors for investing in NSS. Figure 4.4 2002)

AMOUNT RAISED THROUGH TFCs (1995-

Source: SECP Annual Report, 2002

The SECP has streamlined the procedure for issuance of TFCs by reducing cost and simplifying procedure of approval, Stock exchange listing fee, brokerage commission and bankers fee to the issue commission has been reduced. Self-registration has been allowed. TFCs can be issued in tranche. Publication of abridged prospectus has been allowed; and Trustee’s responsibilities have been more clearly defined. 83

Some TFCs are listed on the exchanges but trading is limited due to lack of market makers, professional institutional investors, and an opaque trade-reporting system, hindering price discovery. Additional policy measures, including consideration for creating a risk-free yield curve by issuing longer-term government bonds and establishing an over-the-counter (OTC) market for trading corporate debt papers, would be helpful for the sound development of the debt market and increased trading of fixed-income securities on the secondary market. The future outlook is quite bullish as companies that previously relied heavily on development finance institutions for term borrowings are now accessing the bond market to meet their financial requirements

4.3.19 Future Trade: Future trade provides an opportunity to separate speculative trades from spot or real time contracts. It is practiced all over the world and, for a long time, Karachi Stock Exchange (KSE) had a counter for a forward trade in the selected scrip. Later, this was discontinued for a certain reasons and was restarted in July 2001, at the request of KSE. Future trading in simple words is buying and selling of commodities in future on the basis of standardized contracts. This standardized trading generates massive transactions provides necessary tools for hedging against potential pricing volatility. It is transaction of buying or selling of an asset now, but having it delivered at a future date. A significant factor of such a transaction is that since the delivery is deferred, the asset may be transacted by paying small amount of money (around 5 to 10 percent of the value of asset) to gain control over the asset. Internationally, futures are common in stocks, stock 84

indices, commodities, currencies, and financial instruments. Derivative products give depth to the capital market, providing investors with basic hedging instruments and investment alternatives. Since an asset can be bought or sold by putting forward a smaller amount of money, these transactions are termed to be highly “leveraged” or “geared”. Currently, 13 scrips are being traded at both the KSE and the LSE. Stocks are selected for futures trading primarily on the basis of their liquidity. The 13 selected companies are Dewan Salman, Ibrahim Fibers, Hub Power Company (HUBCO), Pakistan State Oil (PSO), Muslim Commercial Bank (MCB), Sui Northern Gas Pipelines (SNGP), Pakistan Telecommunication Corporation Ltd (PTCL), Nishat Mills, Imperial Chemical Company (ICI), Engro, Fauji Fertilizers and Fauji Jordan. In order to regulate futures trading in provisionally listed securities, i.e. securities that have applied for listing but have not yet been listed, it was considered essential to frame new regulations. Consequently, in February 2002, the Commission approved the Regulations for Futures Trading in Provisionally Listed Companies, 2002 for the KSE. Regulations for futures contracts have been approved for the Islamabad Stock Exchange (ISE) as well and trading is expected to commence shortly. The Commission is currently working closely with the stock exchanges for development of a wider range of derivative products, such as options, index futures, swaps, etc. Futures trade has helped boost the volume and sentiment in the stock market. The SECP has already issued rules for future trading and they are closely monitoring this 85

trade to avoid potential risk in the market. The newly formed futures contracts market has registered substantial growth. The average daily turnover in futures increased from less than Rs. 0.5 billion in September 2001 to more than Rs. 1 billion in June 2002. Average traded value of futures, as a percentage of traded value in the ready market, also increased from about 30 percent to 45 percent during the same period. Figure 4.5

FUTURES MARKET (SEPTEMBER 2001- JUNE 2002)

Source: SECP Annual Report, 2002

4.3.20 Corporate Governance: “It has been universally proved that economies with more transparent corporate sector attract much more higher degree of private investment as compared to ones that do not manage higher level of governance” Khalid Mirza, 2001. In 2001, SECP was eventually able to finalize and implement a Code of Corporate Governance by making it part of the listing regulations, which consequently became 86

applicable to all listed companies, banking companies, Development Finance Corporations (DFIs), Non-Banking Financial Institutions (NBFIs), insurance companies, mutual funds, unit trusts, and companies/ corporations held or controlled by the Government. Essentially based on the Organization for Economic Cooperation and Development’s (OECD) principles of corporate governance, the Code acquired its present shape after extensive consultations with the business community. The Asian Development Bank has provided Pakistan with a US$750,000 technical assistance grant to build institutional capacity for adopting better corporate governance standards in the capital market. This is the second phase of the capital market reforms initiated by ADB that extends to December 2005. The assistance aims to:



Improve the efficiency of the capital market based on solid governance

standards by undertaking a comprehensive review of the current system and recommending strategic changes. 

Enhance stakeholders' understanding of the dynamics of corporate

governance through exposure to international best practices and knowledge sharing. 

Strengthen the capacity of the regulator to promote good corporate

governance in the capital market. 

Achieve transparency, institution building, incentives and accountability

in the corporate sector.

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4.3.20.1 Key Features: The key features of the Code of Corporate Governance include:



Separation of management of public owned companies with ownership



Enhanced disclosure and transparency in operations: Publishing of

quarterly financial statements 

Quality control of audits: Facilitate quality control reviews of auditors

by permitting the release of audit working papers for this purpose. 

Effective representation of minority shareholders and non-executive

directors of companies 

40% independent directors on the board of stock exchanges



Four non-member directors to be nominated and appointed by the

Commission 

Managing Director of each stock exchange to be appointed, removed and

terminated with the approval of the commission. 

The position of vice-chairman of the exchange to be abolished



The chairman to be elected by the Board from amongst the elected

directors. 

Refraining from engaging the auditors for other services except those

specifically permitted. 

Rotate the firm of auditors after every five years (with forbearance in this

respect granted up to December 31, 2003).

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4.3.20.2 Revised Arbitration Procedure: In order to ensure expeditious resolution of investors’ complaints, the Commission has approved a two-tier arbitration procedure for the KSE. Under the new procedure, all claims and disputes of more than Rs. 0.5 million, which are not amicably settled otherwise, should be referred to an Advisory and Arbitration Committee (AAC) for resolution or decision. The Committee consists of three members, namely, one member director, one non-member director and the Managing Director. A claim or dispute could be referred by the AAC to a panel of arbitrators. However, claims and disputes of up to Rs. 0.5 million would be resolved or decided by the Managing Director of the exchange. It is expected that introduction of the new arbitration procedure will have a positive impact on engendering investor confidence. All stock exchanges have been directed to make certain changes in their governance structure to ensure that the exchanges are managed in accordance with internationally accepted norms and in the best interest of the capital market. Stock exchanges have been advised to follow international standards in governance to strengthen their risk management. The initiatives taken by the SECP are aimed at ensuring that the exchanges conduct themselves as a national institution fully protecting the interests of investors who are major stakeholders in the system. Despite consultations with all concerned parties, implementation of the Code was resisted by some elements in the private sector and the Commission had to stand firm to ensure that the initiative was not derailed.

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4.3.21 Electronic Stock Exchange: Efforts are underway for the establishment, for the first time in Pakistan, of an Electronic Communication Network (ECN) as an automated trading system that may function as the fourth stock exchange. The ECN, to be operated by PEX Limited, a subsidiary of Jahangir Siddiqui, who has been in the securities and brokerage business in Pakistan since 1970, would be a self-regulatory entity. Providing investors with enhanced flexibility and reduced trading costs, as well as competition to the established securities exchanges. Trading under this system would require the simultaneous presence of shares and the money to buy these, thus minimizing the role of 'Badla'. An ECN would be free to trade in shares of companies that are already listed with the stock exchanges and can enlist new companies subject to fulfillment of requirements of the listing regulations of the SECP. The establishment of an ECN in Pakistan would provide significant advantages to a variety of subscribers through increased opportunities for trading, efficiency of execution, i.e. lower costs and enhanced liquidity, thus imparting greater depth to the capital market. The cost-less system of ESE will not be limited to Pakistan. There are no geographical boundaries attached to it. ADB fully supports the establishment of the new 90

Electronic Networks (ECNs) and Alternative Trading Systems (ATS) and has explicitly made this a requirement under the ADB-financed Financial (non-bank) Markets and Governance Program (FMGP) approved in December 2002. Stockbroker community at Karachi and Lahore has been up in arms since the time this decision was announced. Brokers allege that the decision by the previous chief regulator was taken "in haste" and that it lacks transparency and smacks of favoritism. Almost all the leading members of KSE have criticized the non-transparent manner in which one company was allowed to establish Electronic Stock Exchange to the exclusion of others. In the US and other countries, it is a collective business in which a large number of companies jointly own and operate such ESEs.

4.3.22 National Clearing & Settlement System (NCSS): The National Clearing Company of Pakistan Limited was incorporated on July 3, 2001 and has commenced operations w.e.f. December 24, 2001 and so far 150 scrips have been added to the NCSS. This project has been prepared with the assistance of the ADB. It is an electronic system developed to replace the individual clearing houses operated in each of Pakistan's three Stock Exchanges by a single entity. The consolidated and geographically neutral Clearing House is located at Karachi, with sub - offices at Lahore and Islamabad. None of the regional markets, including India have such an advanced system of clearing and settlement. 91

Those eligible to become the clearing members in NCSS include: stock broker, bank, company, corporation or institution falling under section 3A of the Banking Companies Ordinance 1969, investment company or asset management company as defined by the company rules, and any other person, company, corporation or institution in such class as National Clearing Company Pakistan Limited (NCCPL) Board may determine. The system is based on rolling system on T+3 based on Continuous Net Settlement (CNS). By adopting the above system design the ratio of trade with settlement has improved and in turn speculative trade is expected to reduce. Under the NCSS, Continuous Net Settlement (CNS) is the main settlement option available to settle trades/transactions received from different sources. CNS is understood to mean a system in which the clearing members would have the option of carrying over their positions to the next settlement day as opposed to the present system in which settlement of trades has to be done at the designated settlement day. Previously, if clearing members were short of funds or securities, they had to resort to borrowing. With CNS, clearing members have the option of carrying over their positions to the next settlement day (subject to allocation, if any), thereby rolling over their position without the constraint of delivery or payment except of a mark to market charge. In CNS, clearing members are required to settle only with the clearinghouse rather than the counter party, which would minimize the risk of default. Other settlement

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options under NCSS include: Balance Order Settlement (BO) and Trade for Trade Settlement. The platform for the NCSS was created in full consultation with market participants, investors and brokers, and adjustments were made to the system as called for. Effective information systems were installed within the SECP. NCSS has provided much required stability to the market by capping the systemic risk to a great extent. With the launch of the System, the capital market has gotten to work under standard rules and regulations and it has also made intra-stock exchange settlements possible. Previously, all three stock exchanges of Pakistan operate their individual clearing houses for trades on their respective exchanges. Other features of the NCSS include a mark-to-market mechanism, formal stock lending and position financing.

4.3.23 National Saving Schemes (NSS): The reforms of the National Saving Schemes (NSS) were launched to deepen the capital market and reduce the cost of government borrowing. To achieve this objective, institutional investors were barred from purchasing NSS instruments from March 2000 and interest rates on NSS instruments have been reduced by an average of 5.5 percent since May 1999. Consequent to the above measures, there has been diversion of deposits from NSS instruments inter-alia to other institutions including the market based security namely Pakistan investment Bonds (PIB), following decline in the investment in NSS. In an effort to further rationalize the rates on NSS instruments, 93

the yield of Defense Saving Certificates (DSCs) has been linked with the PIB of similar maturity since January 1, 2001, while the rates on the other NSS instruments have become market based since July 1, 2001, which will subsequently b e adjusted on semiannual basis. The Central Directorate of National Savings (CDNS) is an attached department of the Finance Division and performs deposit bank functions by selling government securities through a network of 366 savings centers, spread all over the country. As of March 31, 2003 there were a total of about 4.3 million investors with National Saving Schemes (NSS). The seven Savings Schemes currently in operation include: Defence Savings

Certificates,

Special

Savings

Certificates/Accounts,

National

Deposit

Certificates, Savings Account, Regular Income Certificates, Mahana Amdani Account, and Prize Bonds. A new saving scheme entitled “Pensioners’ Benefit Account” was launched during 2002/2003.

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Table 4.7

NET ACCRUALS BY NSS (Rs Billion) J uly -

1 Defense Saving Certificates

2 Special Saving Certificates Registered

March 20021999-00 2000-01 2001-02 2001-02 03 22. 41.2 16.6 0 13.2 14.7 (43.10 (32.5 (24.1 (19. ) ) ) (26.0) 9)

19.4 (20.30 )

9.4 (18.4 )

36. 4 (39.8 )

21.5 (42.4)

41. 3 (55. 8)

% Change 5.1

19.8

11. 3 Regular Income Certificates

26.1 (27.30 )

8.6 (16.8 )

5.50 (5.80 )

3.6 (7.0 )

0 (12.0 )

7.8

-11.9

-6.3

(15.4) (-16.1)

4. 4 Special Saving Accounts National Prize 5 Bonds

-0.03 (-0.03)

10.4 (20.3 )

3

-0.2 (4.7

)

(-0.4)

11. 6 (12.7 )

6.9 (13.6)

6. Others

3.4 (3.60 )

2.5 (4.9 )

1

51.1

4

1.5 (3.0)

0 (12. 2)

50.7

74. 0

91. Grand Total

95.5

18. 0 (24. 3)

6.1

17.5

9.

(6.7 )

2.9 (3. 9)

50.7

8.4

95

(100 )

(100 )

(100 )

Note: Figures within brackets represent share to total

(100) Source:

(10 0) Directorate

of

National savings

In 2003, the real rates of return under the NSS were still attractive as compared to other deposit schemes. Since the weighted average real deposit rates of the schedule banks remained low (around 2.8%), the NSS still offers the most attractive rate of returns to the depositors. This is the main reason why net accruals under the NSS have increased by 46.0 percent in the first nine months of 2002-03, over the same period of last year. In an attempt to restructure the National Savings Organization on modern lines, computerization process is underway. Procedure of maintenance of record at National Savings Centers has been revised threadbare to ensure proper maintenance of record and to make it computer friendly. Due attention and importance is being given to the job of automation of National Savings accounts and the work is expected to be completed in line with the commitment of the Federal Government with the International agencies.

4.3.24 Internet Stock Trading: The Lahore stock exchange earned the distinction of being the first stock exchange of the country to venture into the most modern methodology for the proportion of trading and investment activity in listed shares by adopting Information Technology. 96

Thus the Lahore Stock Exchange has emerged as one of the few bourses among the Asian emerging markets to introduce the internet system of trading, thereby bringing the progress of Information Technology in Pakistan into limelight. Investment interest in the stocks of the listed companies is going to be extended to about 300 cities and towns in Pakistan where Internet facility has been established. As a result, investment interest especially among retail investors is likely to be expanded tremendously and thereby the image of stock exchanges in Pakistan would be enhanced to a great extent. The development of Internet system of trading was achieved through in-house preparation of software known as Ultra Trade. The introduction of Internet system trading activity in stocks and shares would now contribute to speedy promotion of investment activity among retail investors in the country. The brokerage houses are likely to be induced to extend their salesmanship in stock and shares to relatively smaller towns where Internet facility is available in the contrast with their present confinement in the cities where the stock exchanges are located. The process is going to accelerate the pace of capital formation in the country.

4.3.25 Securitization: Companies (Asset backed Securitization) Rule (1999) confers certain advantages to the originator or the company whose assets get securitized. It is an emerging option for NBFI’s to raise capital, which is relevant in the current state of financial markets. Technically speaking, this allows a company to realize its discounted future revenues upfront, which can then be used for long-term investment. However, other than monitoring 97

and rating of the public company, the financial institution willing to lend against such assets will bear the risk of any changes in collateral value. This should force banks and NBFIs to improve their risk management capabilities. SECP has been able to see its way around a few impediments and approve the first securitization transaction, which should be a harbinger for others to follow.

4.3.26 Leasing Industry: The leasing industry, represented by 29 leasing companies, is an important segment of Pakistan’s financial sector. It has experienced commendable growth over the years and has proved to be an alternative source of finance to banking. Some of the leasing companies, however, are inadequately capitalized. To allow leasing companies to access alternative long-term funding sources, the SECP issued the Companies (Asset Backed Securitization) Rules, 1999, which provided the legal and regulatory framework. Under the Program, the SECP has stipulated a minimum paid-up capital of PRs200 million (about $3.2 million) applicable to all leasing companies operating in Pakistan. Leasing companies have made a significant contribution towards development of the financial sector. They have also played an important role in the development of small and medium scale enterprises in Pakistan and remain a significant player in the vehicle financing business

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The leasing sector has witnessed a number of cross-sector mergers during the past few years as well as within the sector. This was due to the efforts of the Specialized Companies Division of the SECP, which has been emphasizing the need for mergers among NBFIs for enhancing their capital base, achieving economies of scale, and improving competitiveness and effectiveness. The measures taken by SECP to promote consolidation of financial institutions have become extremely important for the sector’s revival. However, to improve the future prospects, the leasing companies need to broaden their scope and develop innovative products together with initiating vendor financing arrangements with suppliers of capital equipment, operating leases, and cross-border leases. The presence of commercial banks and development finance institutions in the market has impacted the leasing companies’ margins, but their ability to offer “big-ticket” leasing has enhanced the acceptability of leasing options.

4.3.27 Facilitation Of Investors: 4.3.27.1 Improved Communication Linkages: To broad base the capital market, linkages to cities other than Karachi, Lahore and Islamabad are to be established. The SECP is in the process of developing a policy framework so that the operation is extended to other major cities. Software at all the stock exchanges is to be up-graded so that trade from small cities through the communication linkage is facilitated. An appropriate system design is to be prepared on the above basis.

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4.3.27.2 Investor Education: Various efforts are underway to educate investors about the significant aspects of investing in securities. SECP has published a series of Investor Guides to educate existing and potential investors about the investment risks and rewards, the importance and significance of financial planning and, most importantly, the rights and responsibilities of investors and the recourse available to them. The preparation of the Investor Guide series is a part of SECP’s investor awareness program. Information asymmetries provide undue advantages to certain market participants in case of market failure. SECP, therefore, aims to achieve maximum dissemination/ disclosure of information to all investors. 4.3.27.3 Beneficial Ownership: In order to protect the interests of minority shareholders and to discourage the management of listed companies from making windfall gains on the basis of privileged inside information, every director, chief executive, management agent and person holding 10 percent or more shares in a listed company is required to file certain prescribed returns for beneficial ownership. Also, any gains made by beneficial owners in transactions completed (purchase and sale or sale and purchase) within a sixmonth period are to be reported to the issuer and the Commission and tendered as stipulated in the law.

4.3.28 Mutual Funds: Mutual Funds were introduced in Pakistan in 1962, with the public offering of NIT, which was an open-ended mutual fund in the public sector. The establishment of the Investment Corporation of Pakistan (ICP) in 1966, which subsequently offered a series of 100

closed-end mutual funds, followed this. ICP has so far floated 26 closed-end mutual funds. Later, the government also allowed the private sector to establish mutual funds. Currently there are four open-end and twelve closed-end mutual funds under private sector management. The mutual fund industry, with a total size of PRs26 billion, represents about 6% of the total market capitalization of the stock market. Mutual funds in Pakistan stand at about 2.5% of bank deposits, which is quite low compared to other countries in the region. Significant amendments have been made to both the Investment Advisors Rules applicable to closed-end mutual funds and the Asset Management Companies Rules applicable to open-end mutual funds. The following improvements in the mutual fund industry are noticeable:



Raising disclosure and reporting requirements.



The rules now provide for the establishment of sector-specific funds,

giving investment managers a considerable amount of flexibility in their fund management approach. 

SECP gave approval to the country’s first fixed-income securities fund in

2002. 

An important development in the sector was the extension of the SECP’s

regulatory jurisdiction over the two public sector mutual funds, ICP and NIT. 

A uniform tax rate is now applicable to both private and public sector

mutual funds. 101



Registration of Mutual Funds Association of Pakistan.

However, certain anomalies in government policy still remain. For instance, zakat is charged on private sector mutual funds but not public sector mutual funds, and only units of the National Investment Trust Limited (NIT) qualify as investments under the statutory liquidity ratio of banks and non-bank financial institutions (NBFIs). The overall performance of mutual funds, however, has been less than satisfactory, mostly due to the under performance of the stock market until late 2001.

4.3.29 Insurance Sector: One of the most significant achievements under the Capital Market Development Program was the promulgation of a new Insurance Ordinance in 2000, which replaced the Insurance Act of 1938. The Ministry of Commerce (MOC) drafted the insurance ordinance through extensive dialogue with the insurance industry and market participants. The new ordinance involves:  Higher capitalization and solvency standards.  Sound and prudent management.  Market conduct rules for safeguarding the interests of policyholders.

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 A comprehensive adjudicatory system, supported by small disputes settlement committees, tribunals, and an insurance ombudsperson.  Entering into reinsurance arrangements with re-insurers that have a minimum “A” rating.  All insurance companies have recently been directed to follow the Good Corporate Governance Code in the same way as the listed companies do. Insurance industry in Pakistan is not in a good condition. Out of 43 insurance companies, the stock of only 18 companies was traded at par or above par on 1 st January 2003. The remaining 25 companies’ stock was traded below par. It is noteworthy that insurance companies were asked to enter into reinsurance arrangements with re-insurers that had a minimum “A” rating and later those companies that were unable to do so, possibly due to reduced global insurance capacity, were asked to obtain a satisfactory “claims paying ability” or “financial strength” rating from a recognized rating agency. Insurance companies that could not comply with either requirement were barred from engaging in further insurance business, thereby saving the general public from being offered potentially unworkable insurance policies. The Commission was also able to enforce the minimum capital requirement imposed on leasing companies. The sector is largely in compliance with this stipulation. Further, in order to clean up its corporate registration records, the Commission launched and successfully implemented, carefully devised schemes to regularize the default of private

103

and non-listed public companies with respect to their reporting requirements and to facilitate dormant companies exit out of the register of companies.

4.3.30 Pension & Provident Fund: Pension funds and other contractual savings instruments are major players in the stock markets. Unfortunately, this was not the case in Pakistan when SECP initiated some steps to create incentives for pension funds to actively invest in the capital market. The pension sector in Pakistan is fragmented. The Government has yet to develop a framework for developing a pension and provident fund industry. Government employees with twenty years service (twenty five for military) are entitled to a pension, which is on a defined benefit basis, adjusted partly for inflation and tax-free. This scheme is unfunded. The largest scheme is the Employees Old-Age Benefits Institution (EOBI), a payas-you-go scheme. EOBI assets are expected to rapidly deplete as the scheme approaches maturity and is not fiscally sustainable in the long term. The regulation of the private pension fund industry is now vested with the SECP. The commission has relaxed the investment ceilings for provident funds that can now invest up to 30% of their portfolio in the stock market. It is also considering the possibility of fixing a minimum investment by these funds in the capital market. Pursuant to the pronouncement made in the 2001 budget, the SECP has submitted a proposal for pension reforms and corresponding legislation to MOF, but substantial

104

effort is required for developing a proper legal, regulatory, and tax framework for the sector. It is hard to comment on how much investment these changes will bring. However, even a smaller percentage, say five percent of provident funds, can bring a lot of liquidity and growth in the stock market. The problem at the moment is not just allocation of funds but it is the lack of professional expertise related to fund management in Pakistan. In order to maximize return on pension funds, these funds have to hire professional fund managers to make rational and profitable investments.

4.3.31 Leasing Sector: As financial intermediaries providing medium and long term financing, leasing companies have made a significant contribution towards development of the financial sector in the country. Leasing companies have also played an important role in the development of small and medium scale enterprises in Pakistan and remain a significant player in the vehicle financing business. Previously, establishment of various small leasing companies and entry of other financial institutions into the leasing business had resulted in a fragmented sector with limited opportunities for growth. Moreover, leasing of plant and machinery was adversely affected due to increase in the number of sick units in textile and cement sectors. The capital base of a number of leasing companies was, therefore, eroded due to the large amount of provision that was needed against such non-performing assets.

105

Despite frequent reduction in interest rates and persistent slow down in economic activity, the leasing sector has demonstrated reasonable growth. However, the sector continues to be highly concentrated as six leasing companies accounted for more than 70 percent of total assets of the sector. The following regulatory actions have been introduced in the leasing sector:  Requirement for Increase in Paid-up Capital: By the end of 2003, it is expected that almost all the leasing companies would have met the minimum capital requirement of Rs 200 million. The enhanced capital base is expected to result in greater financial stability, improved resource mobilization capacity and economies of scale to enable leasing companies to compete effectively with larger financial institutions undertaking leasing business.  Mergers and Consolidation: Consolidation in the sector is on the rise and expected to continue as a few more mergers are in the pipeline while some are at an advanced stage of negotiations. These include not only intra-sector mergers but also cross-sector mergers involving modarabas and investment banks. It is anticipated these would result in improving resource mobilization potential and operational efficiency of leasing companies due to strengthening of capital base and economies of scale, respectively.  Suspension of Permission to Issue Certificate of Investment (COIs): The Commission suspended the permission to issue Certificate of Investment (COIs) of several leasing companies since their credit ratings were below the minimum 106

investment grade and issuance of COIs by such companies is in violation of the Leasing Companies (Establishment and Regulation) Rules, 2000. In case these companies fail to obtain a satisfactory investment grade credit rating within a period of two years, the permission to issue COIs will be cancelled. During the two-year time period, these companies have been advised not to issue any new COIs or rollover the existing COI deposits upon maturity.  Permission to Investment Banks and DFIs to Undertake Leasing Business: Licenses to undertake leasing business have been accorded to DFIs and Investment Banks in terms of Rule 18 of the Leasing Companies (Establishment and Regulation) Rules.  Appointment of Administrator: In 2002, special audit of a leasing company revealed gross misappropriation and misapplication of funds by its management. Therefore an Administrator has been appointed according to the Company’s Act to ensure that the management of leasing companies presents a true and fair picture.  Holding of Annual General Meetings: Companies are required to hold their Annual General Meetings (AGMs) within six months of the close of the financial year.  Inspection & Investigations: SECP, on a regular basis, carries out investigations of leasing companies and inspects their books of accounts and interim statements. It also passes strict action against the auditors in case they do not perform their duties properly. 107

4.3.32 Modarabas: The modaraba is an Islamic corporate form that is essentially akin to a two-tier fund structure. In a modaraba, one party (the modaraba management company) contributes its skills and efforts while the other (the modaraba certificate holders) provides the required funds. The profits earned in the business are shared between the management company and certificate holders on a pre-determined basis. A modaraba may be for a specific purpose or multi-purpose, and may be perpetual or floated for a specified period. The difficult operating environment prevailing in the recent past has had an adverse impact on the performance of a number of modarabas. However, despite the persistent economic slow-down, the sector, overall, has performed reasonably well. As per the last audited financial results, the dividend payout of the modaraba sector has been quite encouraging. Fiscal incentives announced in the Finance Ordinance, 2002 for leasing modarabas are expected to give a significant boost to the performance of the sector through tax deferrals and reduced current tax liabilities. Moreover, better monitoring and surveillance methods, recently instituted by the Commission, have resulted in improved compliance by modaraba management companies with the Prudential Regulations and observance of significantly better disclosure standards.

108

Certain amendments have been made in the Modaraba Ordinance and Modaraba Companies and Modaraba Rules, 1981, which are as follows:  Increase in paid-up capital requirement for modaraba companies  De-registration of Modaraba Management Company if it fails to float a modaraba within a reasonable time period.  Enabling provision to allow extension in filing/ circulation of annual accounts under special circumstances  Provision to allow voluntary winding up of perpetual modarabas as against winding up through the Modaraba Tribunal  Rotation of statutory auditors after every five years.  Rationalization and synchronization of Modaraba Companies and Modaraba Rules, 1981 and regulations with the provisions of Modaraba Ordinance.

4.3.33

Demutualization Of The Stock Exchanges:

In response to technological advances, globalization, growing competition and, more significantly, concern for investors’ interests, stock exchanges worldwide are embarking upon a process of demutualization. Out of the 52 exchanges, represented at the 2001 meeting of the International Federation of the Stock Exchanges (FIBV), 32 had demutualized while 20 had approved plans for demutualization. Demutualization transforms an exchange from an entity owned by its members into a commercial, shareholder-owned company. A demutualized stock exchange has a 109

clear commitment to generate competitive returns for its shareholders as well as to protect the interests of all its customers and those of the broader investor community. All members of the FIBV have either completed, or are in the process of, demutualization. The three stock exchanges in Pakistan are, at present, considering demutualization and are engaged in analyzing different models/ structures of demutualized exchanges. The Commission has approved the establishment of National Commodities Exchange Limited (NCEL), for trading in future contract in commodities. The NCEL is the first demutualized exchange and will be sponsored by the three stock exchanges of Pakistan.

4.3.34 Credit Rating Agencies: Credit rating reports serve as useful tools for investors to make informed investment decisions in respect of various listed and non-listed debt instruments. Credit ratings are also one of the factors considered by the regulator in approving issues of corporate debt for public subscription. The functioning of credit rating agencies was regularized by issuing them licenses, based on performance and compliance with the registration criteria. Issuers of corporate bonds and term finance certificates (TFCs) were required to get these instruments rated by recognized credit rating agencies. Similarly, all the financial institutions are required to get credit rating for their financial standing. 110

The Commission has made it obligatory upon credit rating agencies to notify ratings in newspapers within two working days of issuance of ratings and provide copies of rating reports to the relevant stock exchanges and the Commission within 10 working days of the notification of such ratings. Any change in the rating also needs to be intimated immediately. Lately some amendments have been made in The Credit Rating Companies Rules, 1995, which are as follows:  Prior approval of the Commission is required for replacing the chairman and the CEO of a rating agency.  The CEO of a rating agency has been prohibited to hold similar position in any other entity.  The Commission may exempt rating agencies from the requirement of technical collaboration or joint venture arrangements, after a period of five years. This exemption may be granted by the Commission upon being satisfied with the capabilities and performance of the rating agency.  Rating agencies are required to inform the Commission before undertaking the rating assignment of an entity in which any of its directors is holding a directorship by virtue of nomination by the Federal or Provincial Government. Such a director would also be required to submit an undertaking that he would not take part in the rating process of that entity.

111

SUMMARY, CONCLUSION& RECOMMENDATIONS The Asian Development Bank (ADB) is promoting vibrant and efficient financial markets in Pakistan and its Capital Market Development Program was the first major intervention to reform the non-bank financial sector implemented over 1997-2001. The intention behind these efforts of ABD was to create a policy environment to enhance competition and a level playing field, strengthen governance, institutions, regulations, and supervision of the securities market, improvement and modernization of securities market infrastructure and its integration, induce development in the corporate debt market and the leasing industry, introduction of reforms in the mutual fund industry and 112

promotion of contractual savings through reforms of the insurance sector and pension and provident funds. In 2002, when the second phase of the reforms (Financial Markets and Governance Program) was initiated, the major aim of ADB was to strengthen investor confidence through improved governance, transparency, and investor protection and improve operational efficiency and risk management of intermediaries thus reducing financial sector vulnerabilities. The ADB’s program is in agreement with Pakistan's financial systems - a marketoriented, predominantly private owned banking and financial system that operates under a strong regulatory framework, supported by an effective legal and judiciary system, mobilizing the capital needed to finance rapid private sector growth, and improving access to financial services by the poor. ADB’s strategy for the industry and financial sectors in Pakistan emphasized concurrent support for reforms of the capital market and of trade and industry. Based on the direction of this strategy, the Program appropriately analyzed and addressed impediments in the capital market. The program design, based on mission studies and extensive discussions with the Government, was sound and highly relevant. The Program aimed to broaden and deepen the capital market to encourage investment and savings. Reforms of the securities markets, encompassing both primary and secondary markets,

113

were aimed to improve the prospects for issuers to mobilize long-term resources and provide alternative opportunities to suit their preferences.

5.1 IMPLEMENTATION Overall, implementation arrangements were satisfactory. MOF acted as the Executing Agency for the Program. It coordinated and monitored the Program and administered the utilization of loan proceeds. Support to MOF was provided from the SECP on matters pertaining to reforms of the stock exchanges, leasing industry, and mutual funds and from MOC on matters related to insurance industry reforms. The SECP gave full cooperation to program implementation, though delays were experienced, mainly in resolving complex technical issues. MOC, in some cases, was slow to take the necessary action for implementing policy changes related to the insurance industry, often due to lack of up-to-date skills and knowledge of recent best practices in the international insurance market. Program implementation benefited from very tight supervision by ADB staff who made frequent visits and maintained policy dialogue throughout implementation. The Technical Assistance (TA) loan originally had four components: (i) Institutional strengthening of SECP through assisting in formulation of new rules and regulations, developing prudential norms and monitoring compliance, and designing formats of inspection reports; (ii) Development of a self-regulatory framework for the stock exchanges, Mutual Fund Association, and Pakistan Leasing Association; (iii) Development of the NCSS through examining the feasibility of integration with CDC, 114

and through designing its platform as well as preparing the regulations, procedures, and operational manuals of the NCSS; and (iv) Development of the secondary debt market on the OTC market. A fifth component for privatization of mutual funds was added in January 2000, to provide technical inputs to resolve the intricate legal and financial issues required for privatization of NIT and ICP. Of the four original components, the institutional capacity building of the SECP and support for developing the NCSS provided support critical to program implementation. The regulatory framework, assisted by the regulations expert, gave the SECP a solid basis for formulating comprehensive rules and regulations. The information technology support given for establishing the NCSS was indispensable for its operationalization. On the other hand, actual implementation of the self-regulatory framework, and establishment of OTC market for secondary bond market were assessed to be premature in the respective studies conducted, given the current stage of capital market development in Pakistan. The fifth component supported due diligence for the privatization of NIT and ICP and was valuable in assuring progress. The Program brought an important package of reforms to Pakistan, and initiated the process of developing a sound and efficient capital market. It was broad based and touched on all integral components of the capital market. It was successfully implemented and produced some concrete results. At the time of the program closing date of 31 October 2001, of the 58 policy actions under the Program, the Government achieved full compliance with 51, substantial compliance with two, partial compliance 115

with three, while two of the policy actions were considered inappropriate and not implement able. Despite considerable interaction and cooperation with the Government, execution of the Program proved to be more complex than originally envisaged. An international firm was contracted to provide consulting services. The recruitment of the consultants was delayed by approximately 10 months to January 1999 due mainly to the lengthy consultant selection process and protracted contract negotiations because the SECP, acting as the implementing agency, was unfamiliar with ADB procedures. The timeconsuming nature of consensus building for designing the NCSS’s format and the political instability in the region after 11 September 2001 further delayed TA implementation. Moreover, the reprioritization of the agenda by the new SECP chairperson since March 2000 affected the implementation, as adjustments were needed, particularly for inputs from the regulations expert. The mid-course adjustments in the program were mainly due to the realization of the relative importance of each component at the time of implementation. The performance of the consultants was satisfactory. Solid efforts were made by the regulations expert to consult both the Executing Agency and the market stakeholders in the formulation of market regulations, while promoting understanding of modern market practices. Effective information systems were installed within the SECP. Overall, the consultants possessed the capacity to provide solid technical advice as well as flexibility to meet the client’s needs. 116

Although political disruptions delayed the progress of program implementation in difficult macroeconomic circumstances, strong commitment of MOF as the Executing Agency and solid support from the SECP as the implementing agency prevented the Program from derailing and enabled its successful completion. The need for strong ownership of the Program by the executing and implementing agencies was confirmed, as many problems not foreseen at the time of program formulation were resolved through a concerted effort of the officials concerned.

5.1.1

Performance Of Ministry Of Finance: MOF was proactive in the process of implementing reforms. It was instrumental in having the SECP Act, 1997 enacted and the SECP’s becoming operational from 1 January 1999. It also coordinated with the provincial governments to enact the reduction in stamp duty rates. Meetings were regularly held at MOF for reviewing and monitoring progress of implementation and resolving contentious issues. MOF, despite change of key staff following a change of government, continued to show strong commitment to policy reforms and senior officials were readily available for policy discussions with ADB staff. MOF has generally met loan administration requirements and its performance was satisfactory. However, in more politically sensitive areas of reform involving 117

different government authorities, MOF’s role was inevitably limited to that of a mediator. MOF’s commitment to reform overcame numerous political disruptions, and a process for building a market system to provide risk and term financing to the economy was set in motion.

5.1.2

Performance Of SECP: Of the two agencies supporting MOF, the SEC provided quality support. It effectively liaised with the three stock exchanges in executing structural reforms and coordinated effectively with other stakeholders in the capital market for implementing several difficult policy actions. Though there remains sufficient scope for institutional strengthening of the SEC, as its mandate has been enlarged to include regulation of the insurance, pension, and NBFI sectors, the SEC’s commitment to the Program was instrumental in maintaining the momentum of reforms during the 4 years of program implementation. Support given by MOC was in many cases limited, due mainly to staff constraints and MOC’s lesser association with the overall Program. The period of about four and half years in the life of the Commission has been characterized by momentous development in terms of reshaping of the legal framework and regulatory system, development of market institutions and infrastructure, and streamlining of government policies in this regard. Some of these measures constituted a fundamental departure from the past and as a result, the role of SECP has become much more visible in implementation of these radical capital market reforms.

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5.1.3

Performance Of ADB: ADB provided regular monitoring of the Program and regularly sent review missions. Each visit closely monitored the status of Program implementation, identifying impediments and engaging government counterparts in intensive discussions on measures to resolve them within the given time frame. Through program implementation, ADB established a close working relationship with key program counterparts. ADB’s responses to the Government’s requests were quick and approvals and disbursements were promptly undertaken. Significant efforts were made to support capacity building of the SEC, an integral component of the Program, by administering the TA loan flexibly. ADB staff played a crucial role in advancing policy dialogue and supported implementation of several reform components. Given the broad and complex agenda of reforms under the Program and ADB resource constraints, additional technical inputs could have further facilitated resolution of sensitive and multifaceted policy issues. ADB’s extensive and in-depth discussions with government officials on the program design at the time of its formulation have resulted in the successful resolution of all and any problem that hindered the implementation process. Similar efforts should be made mandatory in processing future assistance, particularly in view of the economic and political instability in the sub region. The scope of the ADB’s Program was ambitious. Consequently, it became broad based and in some instances failed to incorporate essential details. The Program required substantial staff resources to make adjustments and fine-tune the policy action during the 119

process of implementation. In some cases, insufficient staff resources impeded timely assistance for program implementation. Moreover, many of the risks identified at the time of program formulation materialized, and overcoming them proved more complex than assumed. The reform program also raised awareness in the Government and among capital market stakeholders, including market participants, of critical issues of governance, transparency, efficiency, and best market practices. Its overall rating is successful.

5.1.4

Support From Stock Exchange:

No reform process can be successfully implemented and its effects fully realized unless all the concerned parties work together in harmony to ensure its development. Similarly, when the capital market reforms were initiated by ADB with the MOF as the executing agency and the SECP as the regulatory body, each of the concerned parties knew that they would be quite useless without support from all the stock exchanges of the country, especially the KSE that dominates the equity market of Pakistan. In the initial period, when the SECP was formed and it started exercising its powers in areas that the members of the stock exchange considered as theirs, there was a lot of friction. The people belonging to the equity markets, the brokers, registrars, executive members of the exchanges were quite resistant to the changes 120

being brought by SECP. The reason behind this was that they considered it a violation of their premises and felt that their freedom to do whatever suited them was being threatened. This resistance to change impeded the growth of the capital markets. However, with the passage of time, when the full impact of these reforms were realized along with improved turnovers and market capitalization at the stock exchanges, they were forced to change their thinking and now the Commission has the full support of the equities market community. Representatives from ISE and LSE state that their reason for supporting the reforms is vested in the belief that these are the means of achieving development, expansion and modernization of the capital markets. The stock exchanges are committed to improve their operational efficiency and it is believed that the capital market reforms will go a long way in transforming the stock exchanges into vibrant institutions capable of meeting the challenges of the new millennium. However, the truth of the matter is that the members of the stock exchange are unwilling to implement self- regulatory mechanism beyond a certain level. So the SECP has to assert its authority. The Stock exchanges have initiated a process to professionalize their management. In organizations that worked for years within a closely-knit group of people, the transition has been difficult. The SECP expended considerable effort in convincing the stock exchange members of the long-term benefits of professionalizing their management and opening up the board to outside directors. Recently, under SEC 121

direction, the stock exchanges have amended their articles of association to require prior approval of the SECP in appointing and removing their chief executive. This measure is expected to strengthen the independence of the chief executive. As the managements of the stock exchanges attain greater degrees of professionalism and independence, the SECP may delegate greater authority to them for the sake of achieving an optimum balance between direct regulation and self-regulation.

5.2 EFFICACY OF CAPITAL MARKET REFORMS The long-term impact of reforms on the overall performance of the capital market still remains to be seen. During the 4 years of program implementation, political and macroeconomic developments were the overriding factors affecting Pakistan’s stock market. The Program did, however, achieve definite results in important components of the capital market. For example, the modernized infrastructure of the stock exchanges, as well as implementation of the first phase of the NCSS, are important achievements that are bound to have positive long-term effects. Introduction of a T+3 trading system on a rolling settlement basis has discouraged speculative trading and reduced systemic risk in the market. The NCSS will help in improving efficiency of the market and in integrating the three stock exchanges. With these developments, a number of recommendations of 122

the Group of Thirty countries (a private sector group composed of representatives of leading banking and securities firms concerned with the working of the international financial system) have been successfully implemented. However, the general perception that members of stock exchanges continue to influence management decisions, at times at the cost of investors’ interests, still remains. The SECP and the boards of stock exchanges must take concrete actions to enhance the professional standards of market participants, the transparency of stock market transactions, and the legal framework for investor protection. The regulatory measures carried out by the Securities and Exchange Commission of Pakistan (SECP) during the last four years have not only received international acclaim but has also made a very positive impact on the stock market and the corporate sector in Pakistan. The effectiveness of the regulatory system is evident from the fact that Pakistan's stock market has been termed as one of the best performing markets in the world with no systemic issues despite several shocks. During July-May 12, 2002-03 the Karachi Stock Exchange has also remained the best performing market among the leading stock markets in the world. As documented in Table and Fig: out of 13 leading stock markets in the world, the KSE share index increased by 74.6 percent in terms of US dollar during July-May 12, 2002-03. Table 5.1

REGIONAL MARKETS INDEX CHANGE IN USD DURING JULY-MAY 12, 2002-03 (Index level in USD)

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Index Level in Respective Currencies 12 May 2003 30 June 2002 2973.31 1770.12 844.29 711.36 633.95 646.32 473.93 505.01 383.49 389.10 2942.78 3244.70 1061.40 1156.35 1531.87 1732.76 1327.42 1552.98 9155.57 10598.55 631.04 742.72 4261.02 5153.71 8221.12 10621.84

Pakistan Sri Lanka Malaysia Indonesia Thailand India Philippine China Singapore Hong Kong Korea Taiwan Japan

% Change in USD 74.60 17.32 -1.91 -2.67 -3.33 -5.96 -11.06 -11.59 -12.55 -13.61 -14.15 -20.14 -20.72

Source: Elixir Securities Pakistan

Figure 5.1

REGIONAL MARKETS INDEX (%) CHANGE DURING JULY-MAY, 2002-2003

Source: Economic Survey, 2003

The Program had no direct environmental impact. Indirect environmental and socio-cultural impacts through economic growth and poverty reduction are positive. 124

The market friendly measures introduced during the last four and half years had a significant impact on investor confidence and the stock market is no longer viewed as having any resemblance with a casino, attracting only die-hard speculators, according. The structural changes brought about by the government have been quite successful in restoring investors' confidence in the equity market. The market has clearly attracted genuine investment as is evidenced by the fact that actual settlement has risen from about one to two per cent of trades in the early part of year 2000 to around 10 to 15 percent in June 2003. Excess liquidity in the financial system, after the withdrawal of banks' deposit lottery schemes and low interest, have played a major role in the recent improvement in stock valuations, and some consolidation at current levels will be healthy for the market. At the same time there is certainly a re-rating taking place based on reducing political uncertainty, greater transparency in policies as well as improving corporate sector fundamentals and earnings growth outlook. On the political front, the military backed technocrat government is likely to continue operating for the foreseeable future. From an investor perspective, the relative stability on the political front is likely to reduce uncertainty. The GoP credibility over the coming months is critically dependent on delivering on the promises of good governance, accountability of corrupt elements and sustained economic revival through reforms.

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On the economic front, an Economic Advisory Board (EAB) has been constituted. It is headed by the finance minister who is a senior banker inducted from Citibank and is well regarded in international financial circles. The EAB is composed of eminent economists, professionals and private sector business personalities without any political background. It has already drawn up an exhaustive blueprint for economic reform on a sector-by-sector basis. A number of other positive factors, including decline in interest rates, removal of economic sanctions, trade concessions, economic assistance extended by a number of countries, restoration of Pakistan’s relations with the International Financial Institutions, successful completion of the Stand by Arrangement and a new three years Poverty Reduction and Growth Facility (PRGF) program with the IMF, Paris. Club debt rescheduling, and Pakistan’s enhanced stature in the comity of nations after September 11, created a positive environment, which led to the resurgence in the market, gradually picking up the bullish fervor. The bullish business trend beginning in the month of January 2002 continued to become stronger day by day and have remained uninterrupted till now. The implementation of the Program revealed the deeply entrenched problem of poor corporate governance and lack of transparency in business practices and market transactions. Many of the frameworks put in place by the Program will be meaningless at the operational level unless the participants adopt higher corporate governance standards. There is an immediate need to strategically address the governance issue that seriously 126

restricts development of the capital market and the economy at large. Basic rules and regulations on market transactions, transparency on trade reporting and timely and accurate disclosure of financial information by the issuers, are some of the fundamental factors still missing in the capital market. With these developments, six out of nine recommendations of the Group of Thirty were implemented. Recommendations implemented relate to trade comparison on T+1, full operationalization of central depository, netting system, delivery versus payment system, T+3 rolling settlement system, and use of International Organization of Securities Commission standards. Recommendations that have not been implemented relate to trade comparison for indirect participants, same-day funds convention, and securities lending through the NCSS. The intricate design of publicly owned mutual funds, involving unusual legal obligations and many politically influential stakeholders, was not fully understood at the time of program formulation. Restructuring and privatizing the funds required political consensus lacking at the time of program inception as well as substantial resources to undertake due diligence. While events unforeseen at the time of program appraisal were inevitable, more efforts may be needed in ascertaining potential areas of technical difficulties and incorporating measures to resolve them. Such efforts at the initial phase of a program’s formulation would have increased the likelihood of timely reform execution.

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Even though these Capital Market Reforms did bring certain improvements in the economy, however the overall effect was not so pronounced.

For instance the

introduction of T+3 has developed an organized system in the economy which did not exist earlier and has become immediately popular amongst those investors and brokers who are willing to do fraud free transactions, while on the other hand it has also pushed back those investors and brokers who prefer keeping little margin and contain an element of fraud in their dealings. So along with its good side of structuring the economy and holding on to fair businessmen prevails it has the negative effect of withdrawing businessmen too. The implementation process of the capital market reforms has been a gradual process. The reform measures introduced so far by SECP are inter-linked. With the continuous monitoring by the ADB over the years, the reforming has been a flexible affair with changes and improvements coming along the way as unprecedented aspects of the capital markets come up. The reforms were carried out under a difficult macroeconomic environment and subdued investor and issuer interest. The main achievement under the CMDP has been the establishment of an effective regulator in SECP as well as improvements in the technological market infrastructure. Progress was also made in improving investor protection, governance of the stock exchanges, and development of the primary corporate debt market, as well improving prudential norms for NBFIs. The ambitious reforms addressed some of the problems and established a good basis for further market development. However, a number of important areas within 128

the financial sector need further attention to bring about the full impact of these reforms. In many ways, the achievements under the CMDP have been necessary but not sufficient. The reduction in the rates of NSS and other government securities, in order to boost the capital market, may have not been a very practical step. One of the objectives of capital market reforms was to eliminate tax and investment policy distortions. Funds generated through contractual savings are mostly contributed by lower and middle class of the Pakistani society. They constitute lifetime savings of the people nearing retirement. It has been a policy of the Government, all along, to invest these savings in a portfolio of relatively less risky securities. Sixty percent of life fund was invested in Government and Government-approved securities. Forty percent of the fund was invested in common stock. Investment in common stock has been raised to fifty percent, exposing this class of citizens to more risk. Such citizens are, by and large, risk-averse. They should not be put to greater risk. However, the Commission failed to take into account the people who are most vulnerable to the reduction in interest rates, the retired and the widows who have been directly and badly hit by this change. These people have no constant source of income and national saving schemes was their one avenue of generating funds without any risk. This segment of our society cannot bear to take on the risk that the stock market holds. In accordance with the transparency measures being adopted by the SECP, the inclusion of three Board members from the outside public in SECP, is not necessarily as 129

effective as they consider it to me. The condition that they can only be bankers or chartered accountants does not necessarily mean that this will eliminate any conflict of interest. On the contrary, bankers have now become members of the stock exchange and have a vested interest in the regulations affecting the equity market. Similarly, chartered accountants are responsible for audit of accounts of various companies and thus they also have a conflict of interest since they will be making the rules for the companies, which are their clients. As the stock market is at a 3 years high and breaking all records, the impact of the reforms seem to be quite obvious. However, people tend to ignore one side of the picture and that is the Initial Public Offering (IPO) market. The capital market reform process is in its fifth year and so far no noticeable contribution has been made to the GDP. The stock market in Pakistan during the last 5 years has revealed that it has failed to achieve its primary objectives of raising capital and thereby contributing to the economic growth of the country. The development of the capital market is considered necessary for the economic growth of any country as it helps in resource mobilization and provides an alternative source of finance apart from the banking system. In Pakistan, however, this is not happening. The figures verified by the SECP confirm that stock exchanges have merely raised fresh capital of rupees 2.0 billion during past 5 years. The number of new listing remains a dismal single digit during the same period. The stock exchanges, in no manner, are functioning as a productive economic agent and cannot be taken as barometers of economic activity. The country requires fresh capital not high trading 130

volumes in little scrips. No one can deny that reforms aimed at governance and transparency of stock market will bring positive results but it is directly dependant on economic development and macro economic stability. Despite regulations to curb insider trading and short selling, these malpractices are still being carried out and in some cases being assisted by the brokers. An interview with the traders at a leading brokerage house of the country, Khadim Ali Shah Bokhari (KASB) Securities, revealed that the phenomenal rise in the stock market at present is a mindless drive by the investors towards greater capital gains. It is driven by speculation, as remarked by the ex- chairman of SECP, Mr. Khalid Mirza: “The Pakistani markets respond 90 percent to speculation and only 10 percent to economic fundamentals”. Most of the people who are actively trading today are unconcerned about the performance of the companies. They are all looking for fast and easy money, which is not so hard since the market is on the rise. Commercial Banks (and other financial institutions) have also jumped into the stock market in the hope of getting quick profits. Many of the potential investors when interviewed, expressed their doubts on the sustenance of the current high levels at the stock exchanges. In their opinion, the only reason they would even consider investing in such a highly speculative and unstable market is because of its good returns which are substantially greater and attractive than the current rates of return on bank deposits and national saving schemes. Hubco’s share price multiplied by four times in the year 2002. What determines stock price? In a nutshell, it is a company’s ability to generate cash flows now and in the 131

future. A company’s ability to generate cash flows depends on its (1) earning power, present and future (2) its plans for future investments and growth (3) its quality of assets, and (4) its quality of management. Hubco’s reports do not indicate any significant change in these fundamentals. This is true about other companies as well, whose share prices rose very high. However, the regulators of the stock markets in Pakistan do not give credence to these fundamentals. Recently the stock price of Chakwal cement rose substantially within a day despite the fact that its factories are closed down and in fact non- existent. What was the reason behind this rise? Daily examples can be taken from the stock exchange, which are proof of high degree speculation and blank selling. Thus more attention is required on the part of SECP in this regard. The KSE-100 index rose 112 percent during the year 2002. But this steep rise is not supported by any significant improvement in the fundamentals of the economy or the stock market. Growth in GDP was less than 3 percent in fiscal year (FY) 2002. The SBP General Index of share prices decreased to 106.7 in FY 2002 from 128.8 in FY 2000, though KSE-100 index increased to 1,770.1 from 1,520.7 during the same period. It may be added that the Karachi Stock Exchange has the highest turnover rate in the world stock markets. The regulators and brokers proclaim it with pride, but this does not seem to a healthy sign. It points to a highly speculative market.

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The number of companies that declared dividends decreased to 370 in FY 2002 from 470 in FY 2000. The number of companies listed on KSE is constantly on the decline. Many companies are actually de-listing themselves. A reason for this could be their unwillingness to pay dividend once every five years or compliance with the disclosure regulations. The Commission should also investigate the cause behind this trend. Circuit breakers are now being applied if there is 7.5 percent change (plus or minus) in price of scrip from its last closing price and trading is suspended in such a scrip. This action is to avoid very substantial rises as well as falls in the share price and thus ensures that the market will not crash as it has in the past. It is a positive step to ensure capital safety to some extent and attract investors. Another discrepancy in the regulation process is concerning the brokerage houses. Some of the large Brokerage Houses in Pakistan, which boast of high trading volumes, are engaged in trading themselves. Therefore, their ability to guide their clients fairly is over shadowed by their own personal interests. They might persuade the investor to sell when the price is low so that they can buy it for themselves. Situations like these do occur on quite a regular basis, thus simply proving that the SECP needs to be more vigilant in this regard. Another thing that is badly haunting the market is “Badla.” Badla is a kind of interest and unofficial way of lending money to encourage the people to buy shares on 133

borrowed money for a very short period of time and just pay only interest plus commission rather than entangling their total capital. As the banks encourage the businessmen to expand their business through borrowed money in the same way, the brokers encourage the jobbers to play in the market by borrowed money.

But in the

business transaction the assets purchased by borrowed money remain in the possessions of the borrower and the banks have nothing to do with it, but in badla transaction the buyer gets nothing except a memo of confirmation. In bank borrowing, the borrower obtains money physically and pays principal plus principal interest while in badla transaction; the buyer pays difference of his purchase price and market price plus commission. The most negative aspect of badla trading is that one can buy huge quantity of shares by involving a very meager amount. In actual buying the transactions is one time and ownership of shares is transferred from seller to buyer permanently while in badla transaction only the value of the shares is changed and ownership is shifted to buyer in token. In short, shares trading under badla transactions are an artificial way of business means, aiming at luring the innocent people and minting money from them. As a very small amount of money is enters the market under badla while heavy number of shares are traded this is the reason that it causes negative impact on the market instead of bringing any significant and positive effects. SECP has been unable to highlight the importance of good micro level performance as it contributes to a sound macro level performance. In Pakistan however, 134

emphasis is only on good macro reform and good governance whose focus is usually on tax collection and administration, public service delivery, law enforcement, judiciary and operations of public sector organizations. The assumption that once a company is privatized, the entity will govern itself efficiently is not the key to turn around micro levels. While actual practice has proved this assumption wrong, the pains of right sizing also feed in to the already bad law and order situation. This issue is circular. Corporate governance in the private sector is a subject, which remains taboo so far. Unless the vital constituent components of the economy are turned around, macro economic prosperity will remain a distant dream. Capital market development is market driven and the establishment of new exchanges (or merger of existing ones) can't be mandated but one has to create conditions for market participants to come forward when the timing is right. No one really has a problem with ECN. However, granting a license to one party is something that has caused a rift between the broker community and the Commission. Further more, allowing the ECN to trade around the clock is also something that is unfair to the other stock exchanges. However, people in favor of ECN say that the fourth electronic stock exchange would end the fifty-year-old monopoly of stockbrokers on the market. Traders who cannot afford to purchase costly brokerage licenses would also be able to directly buy and sell. It would reduce transaction costs and is also a technologically feasible idea. If it can add value to the existing stock exchanges it should not be a bad idea at all.

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However a better course of action would have been to launch ECNs through the existing stock exchanges. Plans are also underway for a national stock exchange. However, due to resistance by the stock exchanges community is definitely blocking its implementation. All the board members of the three stock exchanges have a vested interest in the rejection of this proposal. They fear that their control over their respective exchange will diminish and they would instead become one of many directors of a national exchange, with no real monopolistic power. The KSE is also reluctant in this regard since it is the most outstanding market of the country and its personal achievements may be taken out of the limelight since it will lose its independent identity and be incorporated into a single entity, with the negative aspects of LSE and ISE performance cutting out on KSE’s accomplishments. Even though SECP employees are restricted from investing in the capital market, they still find ways to maneuver around this regulation and trade in the name of family members or other people. Since they are the regulators of the capital markets and are aware of all the ins and outs of the policies likely to affect the markets, it is just another form of insider trading, against which the SECP itself is fighting. The T+3 system is generally criticized as the system, which has depressed the market, but results have shown that with practice and better understanding, the investors and members are now appreciating the system and even moving towards T+1. 136

T+3 and many other reforms introduced in the market over the past four and a half years are the practical implementation of the ADB’s proposal for developing the capital markets. Most of these proposals have been successfully put into practice, with only a handful of them left since Pakistan’s macro economic environment and regulatory framework either do not allow or hamper the successful implementation of these reforms. However, all of the objectives of CMDP have been realized. The implementation process may not have been as easy or influential as desired by the ADB, but for an unstable country like Pakistan, the results achieved so far have been like a blessing. Due to the conflict of interests of the regulatory authorities and the people being regulated, the reforms may not have been put into practice fairly and justly and in their true spirit. Changes in the regulations came along the way to adjust the reform program according to the need of the capital market. No steps have been taken to upgrade the Pakistan Insurance Institute and there are no satisfactory arrangements in the country for education and training of insurance professionals in the insurance sector. Absence of a well-established education and training institution for insurance is being increasingly felt by the insurance industry, which is facing difficulties in recruiting qualified personnel and in upgrading skills and knowledge of its employees through training. The Securities and Exchange Commission of Pakistan (SECP) has accelerated its drive to enhance the efficiency of the stock exchanges and ensure protection of the interest of investors. Disclosure requirements are being made more stringent. Another 137

phenomenon taking shape with the general rise seen in the stock markets is the revival of the mutual fund industry. The funds are becoming more attractive and their portfolios attracting new investors to capitalize upon the current trends. With the recovery of Pakistani stock market, it is the opportune time for foreign funds to make their entry into Pakistani stock markets. The long-term outlook is promising and the markets are giving enough movement to pick up blue chips at attractive prices with good chances of reaping sizable capital gains on medium to long-term basis. There is ample scope for income funds to be launched. The reforms introduced were necessary for bringing the stock market to the international operational, technical and regulatory standards and, to gain and maintain the confidence of investors as one of the best regional stock market. The primary objective of these reforms was to enhance the confidence of the investing public, in the integrity of the governance and operational systems in the Stock Exchanges. It is believed that after the implementation of these reforms the Exchanges will become front line regulators. In the long run, the onus of having and maintaining public's confidence will lie with on the Stock Exchanges themselves. Although many of the basic concepts and frameworks have been put in place, meticulous work will be needed for the capital market to develop and function effectively as a medium for channeling risk and term funds efficiently to the economy. Implementation of the concepts and frameworks is difficult given the current capacity of the regulator and market participants. For example, enforcement of market discipline, 138

vital for winning investors’ confidence, is still limited. Insider trading and front-running remain common practices in the stock exchanges. Enforcing market regulations will require substantial capacity building for staff of the regulatory bodies, as will upgrading the surveillance systems. Continued support is essential for implementing the concepts and frameworks developed under the Program at the practical level.

5.3 CONCLUSION In the past, the stock markets of Pakistan had been hampered by weak infrastructure and regulatory restrictions on institutional investors who were required to invest a large proportion of their funds in Government securities. Key market participants such as mutual funds, insurance industry and leasing companies were prevented from playing a full role in the capital market by constraints such as tax anomalies, a predominance of the public sector and regulatory weaknesses. At the behest of Asian Development Bank, SECP initiated a series of reforms with the view to strengthen its role as a regulator of the capital market as well as to put the country's securities market on sound footing. Momentous developments in the regulatory framework during the past four years have not only virtually transformed the functioning of the market as a whole but also significantly altered perceptions towards the available risk-return tradeoffs. As a result of these measures public measures in the 139

stock market has been restored to a large extent as many unscrupulous elements are finding it difficult to function in a tight regulatory system. Expected results of the capital market reforms have been largely realized with a stronger regulatory framework in the capital market; effective functioning of the SECP; updating of regulations on mutual funds; privatization of public sector mutual funds; and enactment of a new insurance law and issuance of rules. Two public sector insurance entities have been restructured and interest rates on the national savings were rationalized and are being adjusted periodically based on market signals. The progressive steps taken for enhancing efficiency and transparency of exchanges as well as risk management measures taken over the years have helped in increasing opportunity and higher turnover at the exchanges. Commission officials have been able to demonstrate through a large number of measures taken over a broad front that the SECP has been able to advise a corporate sector and capital market that is far more responsive to needs of small shareholders and investors. Also, the marked improvement in efficiency and effectiveness of the Company Law Division has meant greatly improved service to the general public as evidenced by company registrations occurring within 3 days, change registration within one day, and name availability on line. Appointment of independent directors on the Boards of the stock exchanges and independent non-broker Chief Executives to manage the stock exchanges is likely to send positive signals to international investors besides creating confidence among the investors within the country. Implementation of T+3 is a major 140

achievement that, with the passage of time, has improved the efficiency and transparency in the capital market. The observance of enhanced accounting standards, reliable audits, institutional strengthening and capacity building of the Securities and Exchange Commission of Pakistan (SECP) have been the hallmark of the reform program. As a result of these measures, there has been a marked improvement in the conditions prevailing in the capital market. The State Bank of Pakistan has driven interest rates down over the last two years. The yield on six-month government treasury bills has declined from 12.5 percent in July 2001, to 2 percent today. By contrast, companies in the KSE pay an average dividend yield of 10 percent. Therefore, for many people, investing in the equity market is the best way of making money, Along with domestic investors; foreigners and overseas Pakistanis are now also offered every possible incentive and opportunity to undertake investment in projects of their choice. These reforms have made a very positive impact on the capital markets in Pakistan, which is reflected by the figures of capital raised through stock exchanges from Rs 3 billion in 2000 to Rs 16 billion in 2003. Total turnover of shares on KSE was 36.2 billion in June 2003. This research study therefore comes to the conclusion that the reform process initiated by the ADB has been successful in modernizing the securities market of Pakistan and thus providing the people with a safe and viable mode of investment, properly regulated by different authorities. Minority interest is safeguarded and a more fairer, efficient and regulated system with fewer constraints has been the end result. The 141

reforms have been a blessing for the investment starved nation and further aim to stimulate investment, economic growth and job creation in Pakistan. With the recovery of the Pakistani stock market, the long-term outlook is promising and the markets are giving enough movement to pick up blue chips at attractive prices with good chances of reaping sizeable capital gains on medium to longterm basis. The stock and capital market reforms will have long term impact on both the markets and in protecting the interests of the investors. There is also ample scope for income funds to be launched. In short, Pakistani stock markets are on the road to better performance and efficiency. Although their volatility, an essential part of all emerging markets, creates higher risks they also magnify the potential for higher returns for any investor who has the patience and sophistication to participate in the growth of this emerging market. The stock exchanges should act as a catalytic agent to the economy. They should provide blood to the economy i.e. capital. The direction is correct and the reforms must continue. If to continue the reforms, people have to continue, then these people must also continue, because unfortunately in Pakistan, if people change, policies change and that must not be allowed to happen. There are strong lobbies against these reforms and at the very first opportunity, they would push them back or slow them down or make them ineffective. At the ultimate, these reforms mean to make Pakistan self-reliant and to increase its savings rate. These mean more taxes for the government, more developmental budget, more industries and more money allocated to education and hospitals. These 142

mean to make Pakistan less dependent on foreign aid, so that it will stand in the comity of nations with its head high and less vulnerable to international pressure.

5.4 RECOMMENDATIONS Although, a lot has been achieved during the last 4-5 years, however there is a lot, which still needs to be accomplished. Market forces demand a more vigorous financial market in the country. Some measures that can be taken to improve the functioning of capital markets in Pakistan are:  Efforts must be made to increase the depth and breadth of the market by limiting family ownership and encouraging new industries.  To improve financial reporting and disclosure, more vigorous regulations are required. The accounting profession should try to improve its self-regulation.  One way to ensure impartiality and remove conflict of interest of the auditor is to allow companies to engage auditors on a non- renewable fixed term contract.

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 To curb speculation and carry over trading, the Futures market needs to be strengthened. Instead of ‘badla’ financing, the commercial banks need to be encouraged to extend financing facility to traders.  Better regulation of insider trading is essential. The directors and senior executives should be required to disclose their sales and purchases on a regular basis.  Given the technical nature of issues involved in the insurance and pension industry, absence of organized education and training facilities must be addressed as a matter of priority.  To create flow of real capital, primary markets need to be developed. SECP should devote part of its expertise and attention to the creation of enabling environment for development of the primary market.  Outside directors on the stock market boards need to be those who have no conflict of interest, and also possess requisite knowledge. Nominations from research and academic circles could be one of the solutions.  Investors should make thorough investigations about the companies before they buy their shares. They should not get carried away by the market manipulators. Investing in blue chips is much easy but at the same time they should expand or keep their investment portfolio diversified.  Measures to popularize the stock market through effective marketing efforts.

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The capital market reforms should not be implemented and left to rotate in the economy themselves. The responsible organizations should very closely monitor them especially any anti reforms measure should be taken care of. Also as there are still some reforms pending or are in the process of implementation, maybe a wider outcome will be observed later once all the reforms are made functional in the economy. Presently it is better to clean up the mess and develop a real market that would function as financial intermediaries in its true sense. The main lesson to be learned is that strong government ownership is critical to the success of policy and institutional reform, and sharply focused technical assistance projects have a better chance of success.

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