Saturday December 09, 2023

Capital market death

October 15, 2023

Capital markets in any economy characterize the nature of that economy. The depth of such markets refers to how much capital exists in such a market, while the breadth refers to how much such a market is spread out to various sectors.

A vibrant capital market with adequate breadth, and depth provides the necessary foundation that enables availability of capital, and growth of businesses in any economy. In most cases, capital markets can largely be segmented into a market of debt, and into a market for equity. Like every market, there is a demand side and a supply side. The supply side in this case refers to the available supply of capital, while the demand side refers to the demand of capital from various industries, etc.

In the particular case of Pakistan, growth of capital markets over the last one decade has been anaemic at best. The debt market is largely dominated by the sovereign, which continues to raise debt to plug its incessant fiscal deficits, largely relying on financial institutions to provide the necessary capital, which in turn rely on local depositors to provide the capital. The structure of the debt market is such that the demand emanates only from the sovereign, while supply is consolidated by banks through its depositors. As banks effectively act as conduits for sovereign debts, depositors continue to get the short-end of the stick, resulting in sub-optimal pricing (interest rates) of such debt.

A vibrant market in such a context would have allowed individuals and institutions alike to lend directly to the government through development of simple and intuitive financial products that can be used by the masses. However, in the absence of such simple products, an ordinary depositor is beholden to the bank that effectively locks in a relatively risk-free profit by taking depositor money, and allocating 70 per cent of it to various government assets.

The situation is worse in the case of Islamic banks, where depositors get barely any return on their deposits, while the Islamic banks continue to lend to the government at much higher rates. Given the prevalence of historically high interest rates, banks have even been pushing customers to move towards current accounts (and not get paid anything for their deposits), or towards Islamic deposits (which do not have a fixed rate on savings accounts), to lock in higher profits.

The banking regulator being aloof from such anti-consumer activity, continues to turn a blind eye towards depositor interest, as the ordinary depositor continues to be fleeced by banks. In a vibrant capital market where the market structure actually incentivizes suppliers of capital to directly lend to the government, that spread would be considerably lower, thereby also improving interest rate for the government, as well as for the depositor alike. The government with its never-ending reliance on borrowed capital could have created financial products that tap the supply of capital utilizing existing technology rails. The current products that exist, such as the IPS account, are so arcane and difficult to operate that no ordinary depositor can understand or utilize them effectively.

On the equity market side, the number of investors has largely stayed flat over the last ten years, staying in the range of a quarter of a million investors, while the number of investors in economies of similar income levels have increased substantially over the years – sometimes increasing more than five-folds during the last ten years. The number of listed companies on the Pakistan Stock Exchange continues to decline as businesses avoid being listed on the stock exchange, or are actively trying to de-list from the stock exchange.

The average turnover (or trading activity) on the exchange continues to steadily decline over the last many years. Similarly, the number of new products that have been launched on the exchange in the last decade that have found any commercial success is close to zero. As the world moved towards Exchange Traded Funds, we are yet to create a vibrant market for this. Similarly, the local market is yet to even introduce derivatives, or other structured products for investors. In the absence of any competition, the exchange is run as a small fiefdom that continues to alienate both investors, and companies alike.

The structure of the market is such that among the recently announced top-25 companies on the exchange, around 21 companies are directly or indirectly dependent on the sovereign, which provides largesse in one form or another. The sovereign either provides subsidized input costs in the case of fertilizers, a guaranteed return in the case of power producers, is either the major shareholder in the case of many state-owned entities, is either the biggest customer in the case of banks, or it essentially creates a market structure that only benefits a few market participants, in the case of automobile manufacturers.

Most of these entities listed on the stock exchange may actually not remain competitive in a global market once the government support is removed. This is precisely why the country is not able to increase its exports, because its businesses are not attuned for market competition, but have evolved to being dependent on government largesse to create an uneven playing field that inadvertently constrains growth of the market, and the economy at large.

The fundamental structure of the capital markets in the country needs a complete revamp. There needs to be a move towards utilization of more technology, and creating competition at various levels. this can only be achieved if there is less reliance on government handouts, and the government actually encourages competitions and facilitates development of competitive markets. Gatekeeping access to markets whether through high barriers of entry, or through oligopolistic market structures only results in a higher cost of capital for the economy across the board, and creation of businesses that are uncompetitive on a global or even regional level.

The writer is an independent macroeconomist.