A Publication of the South Asian Federation of ...

A Publication of the South Asian Federation of Exchanges

Design and Editorial Coordination by

South Asian Financial Markets Review A publication of the South Asian Federation of Exchanges Executive Committee Chairman Adnan Afridi, Karachi Stock Exchange Vice Chairmen Fakhor Uddin Ali Ahmed, Dhaka Stock Exchange Joseph Massey, MCX Stock Exchange Rashid A Al-Baloushi, Abu Dhabi Securities Exchange Members Muhammad Lukman, National Clearing Co. of Pakistan Shanker Man Singh, Nepal Stock Exchange Secretary General Aftab Ahmad Chaudhry Members of SAFE (in alphabetical order) • • • • • • • • • • • • • • • • • • • • • •

Abu Dhabi Securities Exchange Bombay Stock Exchange Ltd Central Depository Bangladesh Ltd Central Depository Company of Pakistan Ltd Chittagong Stock Exchange Ltd Colombo Stock Exchange Dhaka Stock Exchange Ltd Global Board of Trade Ltd Islamabad Stock Exchange (G) Ltd Karachi Stock Exchange (G) Ltd Lahore Stock Exchange (G) Ltd Maldives Stock Exchange (Pvt.) Ltd MCX Ltd MCX Stock Exchange Ltd National Clearing Company of Pakistan National Commodity Exchange Ltd National Multi-Commodity Exchange of India Ltd National Securities Clearing Corporation Ltd National Stock Exchange of India Ltd Royal Securities Exchange of Bhutan Ltd The Nepal Stock Exchange The Stock Exchange of Mauritius Ltd

South Asian Financial Markets Reivew 2010 Editorial and production by Financial Technologies Knowledge Management Co. Exchange Square, First Floor, Suren Road Chakala, Andheri East, Mumbai : 400093, India Tel : +9122 6731 8888 Fax : +91 22 67269541 Email : [email protected] www.ftkmc.com Editorial and Coordination Team from FTKMC Dr. Bandi Ram Prasad Shilpa Puri George Oommen Yogesh Kale Pinky Jain Marketing Maggie Rodrigues

South Asian Financial Markets Review is a new addition to the literature on economies and financial markets in the South Asia region. The Review is brought under the aegis of the South Asian Federation of Exchanges, the regional forum of exchange industry in South Asia. We are happy to present the first issue of the Review. The Review presents articles on regional economic and financial overview, developments in regulation, corporate banking, mutual funds, exchange-traded funds, and commodities, along with key ecnomic and financial data on the member countries of SAFE. South Asian Financial Markets Review has the potential to emerge as an important instrument in regional economics and finance and it will be our endeavour to strive to reach this objective with the active participation of institutions and professionals in terms of guidance, suggestions, and support.

Dr Bandi Ram Prasad President, FTKMC

Adnan Afridi Chairman, SAFE MD & CEO, Karachi Stock Exchange

Joseph Massey Vice Chairman, SAFE MD & CEO, MCX Stock Exchange

Aftab Ahmad Chaudhry Secretary General, SAFE

The Nepal Stock Exchange

Royal Securities Exchange of Bhutan Ltd

Central Depository Company of Pakistan Ltd Islamabad Stock Exchange (G) Ltd Karachi Stock Exchange (G) Ltd Lahore Stock Exchange (G) Ltd National Clearing Company of Pakistan National Commodity Exchange Ltd

Central Depository Bangladesh Ltd Chittagong Stock Exchange Ltd Dhaka Stock Exchange Ltd Bombay Stock Exchange Ltd MCX Ltd MCX Stock Exchange Ltd National Multi-Commodity Exchange of India Ltd National Securities Clearing Corporation Ltd National Stock Exchange of India Ltd Colombo Stock Exchange Maldives Stock Exchange (Pvt.) Ltd Global Board of Trade Ltd The Stock Exchange of Mauritius Ltd Abu Dhabi Securities Exchange Exchanges arranged in alphabetical order.

Introduction Financial markets in South Asia are experiencing intense growth and diversity. Some of the fast-growing, emerging and frontier markets are located in this region as also a dynamic and enterprising professional community well conversant with the nuances of trading, technology and operations. Besides creating new markets and financial products, various South Asian countries have also introduced several rounds of reforms in the recent period, which gave a big boost to the growth of the financial services industry. There is a major spurt in terms of institutions, intermediaries and investors, which reinforce with each another in making South Asia one of the most vibrant regions that is poised to attract huge interest from international investors. In this context, a need was felt to create a forum and platform that will bring together professionals from diverse range of financial institutions in the South Asia region to share their insights and perspectives on numerous aspects of policy, regulation and market practices in the financial markets. South Asian Federation of Exchanges, an institution engaged in the promotion of cross-border cooperation in the regional exchange industry, took up the initiative of creating this annual publication, South Asian Financial Markets Review. The first edition, which is slated for release on the eve of the South Asian Capital Markets Conference being held in Mauritius on April 22-25, 2010, has already received a very encouraging response from contributors from various countries. The Review was able to generate interest and support from senior professionals in major countries of the region, including India, Pakistan, Bangladesh, Nepal, Bhutan, Maldives, and Mauritius, who shared their thoughts on several aspects of the functioning of the financial markets. SAFE will endeavour to make this Review an important and influential publication on major aspects of growth, functioning and development of the financial markets. SAFE will also attempt to bring together a diverse range of professionals and experts in the region to discuss and deliberate on issues of mutual interest. We look forward to receive active support and participation of the institutions in the South Asia region for the success of the Review. We acknowledge and place on record our appreciation for the services provided by Dr Bandi Ram Prasad, Shilpa Puri, and Pinky Jain from Financial Technologies Knowledge Management Company (FTKMC), who have worked very hard in bringing out this maiden issue of the Review. We are also thankful to George Oommen and Yogesh Kale, of the same company, who provided valuable editorial and creative support. We hope to receive comments and suggestions as well as insights on various aspects of developments of the South Asian financial markets in making the Review an important instrument of information.

Aftab Ahmad Chaudhry Secretary General, SAFE

Joseph Massey Vice Chairman, SAFE MD & CEO, MCX Stock Exchange

Adnan Afridi Chairman, SAFE MD & CEO, Karachi Stock Exchange

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Disclaimer South Asian Financial Markets Review is an endeavour of the South Asian Federation of Exchanges (SAFE) and Financial Technologies Knowledge Management Company (FTKMC) to provide a platform for discussion and interaction on major developments and important aspects of the financial sector. The Review comprises inputs and analysis generated by in-house research staff as also contributions from experts and professionals from outside. SAFE & FTKMC acknowledges the support and cooperation of a wide range of market professionals and, in particular, contributors to this issue of the Review. The views, outlook, and forecasts expressed by the authors are personal opinions expressed in individual capacity and are not necessarily those of their respective institutions or that of SAFE / FTKMC or any constituent of the Financial Technologies Group. The views expressed by the individual authors are not checked whether they are in consonance with the official policy statements or reports of the respective governments. Authors whose articles appear are related to various financial institutions in respective countries and no specific information is available on their affiliations and relationships with various organizations in the respective countries. The articles taken in the Review are only from the point of view of insights presented by the authors on various aspects of markets in the respective countries and no other inference may be taken from these. Data and information presented in the articles could vary from one another based on the references used by the respective authors as also the context in which the article is written. We believe that the data and information used is authentic and obtained from reliable sources. SAFE / FTKMC are not responsible for the authenticity or the accuracy of the data presented and analysis made on various aspects of the global and domestic financial markets in this Review. No separate checking and validation of the authors or the data presented by them or the sources from which the data was obtained is done either by SAFE and FTKMC. SAFE / FTKMC is not aware of and is not responsible for any particular interest or point of view expressed by the authors on any aspect of the market. The Review is academic in nature with main purpose being that of interacting with major stakeholders in the financial system and the underlying objective being exchange of ideas and sharing of perspectives rather than pursuing any monetary and commercial outcome. Thus any views and opinions expressed in this Review should be taken for the purpose of knowledge and information only and not for taking decisions on any investment. Due care has been taken and no effort has been spared to ensure the facts and data presented. SAFE / FTKMC assumes no responsibility for any discrepancy in the information presented or for any errors and omissions. Readers are advised to make appropriate judgements without any prejudice or compulsions prior to taking any decisions based on the information contained in the Review. No part of the information presented in the Review may be reproduced in any form without the prior permission of SAFE / FTKMC. Request for any permissions in this regard may be sent to [email protected]

08.33 GS 201 07.59 GS 2016 2034 GS 2020 GS 2510 202 07.50 GS 2014 2022 1109 GS 2020 GS 201 GS 2002 GS2017 GS 2016 07.50 G 3107 06.34 GS 2020 08.33 GS 2034 GS 201 07.59 GS 2016 2034 GS 2020 GS 2510 202 07.50 GS GLOBAL 2014 2022 1109 GS 2020 GS 201 07.50 G FINANCIAL MARKETS GS 2002 GS2017 GS 2016 PROGRAMME 3107 06.34EXPOSURE GS 2020 08.33 GS 2034 GS 201 HONG KONG t SEOUL t SHANGHAI 2034 2020 GS 2510 202 t KUALA LUMPURGS t BANGKOK 07.59 GSSINGAPORE 2016 07.50 GS 2014 2022 1109 GS 2020 GS 201 GS 2002 GS2017 GS 2016 07.50 G 3107 06.34 GS 2020 08.33 GS 2034 GS 201 07.59 GS 2016 2034 GS 2020 GS 2510 202 A Financial Technologies Group Initiative

P R E S E N T S

BACKGROUND India is emerging as a powerhouse in global finance. In addition to its rapid growth in domestic markets, the Indian financial sector is poised to play a significant role in regional and international finance. Its growing influence in global financial policy forums such as IOSCO, BIS and Financial Stability Forum and its aspiration to become an international financial centre will further enhance its standing and recognition in the world of finance. OBJECTIVE Growing maturity of Indian finance requires professionals with superior and diverse range of skill-sets and expertise. Global Financial Markets Exposure Programme (GFM) is an Executive Development Programme, designed to provide senior finance professionals with unique opportunities in grasping the functioning of the international financial markets in the rapid growth region of Asia. The programme is an endeavour to develop and prepare global financial experts from India, which is pertinent for Indian finance to chart its own growth as also engage in the global business. PROGRAMME Global Financial Markets Exposure Programme among others, will mainly consist of a. Lectures and presentations on emerging trends and developments in global finance by experts b. Meetings/interactions with policy makers, regulators, exchange officials and market participants c. Networking for establishing business linkages and exploring new opportunities d. Visit to leading financial institutions in various centres The programme is for a two-week duration, which will provide enough scope to hold meetings and interactions with diverse range of professionals in six major financial centres in the Asia region.

PARTICIPATION Senior professionals engaged in financial services industry, with decision making and market development responsibilities, are encouraged to participate in this programme. Business Class/Economy travel options are available, though all the participants will be staying in one place. DETAILS Further details of the programme could be obtained by writing to [email protected] or visiting www.ftkmc.com. For any other assistance, please contact Afzal Maggie +91 99302 68329. Exchange Partner FINANCIAL TECHNOLOGIES KNOWLEDGE MANAGEMENT CO.

Exchange Square, 1st Floor, Suren Road, Chakala, Andheri (East), Mumbai - 400093. India. 5FM t'BY &NBJMLOPXMFEHFGPSNBSLFUT!GULNDDPNt8FCTJUFXXXGULNDDPN

Systematic Development of Markets through

INFORMATION INNOVATION EDUCATION RESEARCH

CONTENTS TABLE OF CONTENTS

10

South Asia: Profile of a Growth Region

12

Overview: Economy, Finance & Markets

Bandi Ram Prasad, President, Financial Technologies Knowledge Management Company

BANGLADESH 18

Importance of Knowledge Based Economy in South Asian Countries

20

A Close-Up of the Markets

22

Bangladesh on Growth Path

24

Emerging Trends in the Capital Markets

27

Rating Industry Is Evolving

Fakhor Uddin Ali Ahmed, President, Chittagong Stock Exchange

Wali-ul-Maroof Matin, Chief Executive,Chittagong Stock Exchange Annisul Huq, President, Federation of Bangladesh Chamber of Commerce and Industries Mohammed Nasir Uddin Chowdhury, Chief Executive Officer and Director, LankaBangla Securities Limited M Syeduzzaman, Chairman, CRAB

BHUTAN 32

Growth of Financial Markets

Dorji Phuntsho, Chief Executive Officer, Royal Securities Exchange of Bhutan Ltd.

INDIA 38

Primary Markets Beckon Investors

40

Mutual Fund Industry May Witness Consolidation

42

South Asia Needs More Commodity Exchanges

46

A Regulator Is Needed for Fixed Income Markets

48

ETFs Have More Potential in India

M V Ramnarayan, Director, Link Intime India Pvt Ltd Santosh Das Kamath, Chief Investment Officer, Franklin Templeton Fixed Income, India Ashok K Mittal,Vice President and Country Head, Karvy Comtrade Ltd S Ramesh Kumar, Head, Fixed Income Securities and Foreign Exchange, Asit C Mehta Investment Intermediaries Ltd. Rajan Mehta, Executive Director, Co-founder of Benchmark Asset Management Company

MALDIVES 52

Development of Capital Markets

Fathimath Shafeega, CEO, Capital Market Development Authority, Maldives

TABLE OF CONTENTS MAURITIUS 56

Centralized Clearing of OTC Derivatives: Panacea or New Problems?

60

The Stock Exchange of Mauritius: Evolution and Challenges

Joseph Bosco, Deputy Managing Director & Chief Operating Officer, Global Board of Trade Sunil Benimadhu, Chief Executive, Stock Exchange of Mauritius Ltd.

NEPAL 64

Capital Markets Face Regulatory Challenges

66

Nepal Strives for Inclusive Growth

70

Dividend Policy of Nepalese Enterprises

Surbir Paudyal, Chairperson, Securities Board of Nepal Binod Atreya, Chief Executive Officer, Nepal Bank Ltd Nabaraj Adhikari, Deputy Director, Securities Board of Nepal

PAKISTAN 78

Pakistan Foresees a Better Future

82

Corporate Banking

84

Capital Markets Show Resilience

86

Volatility Is an Opportunity

90

Fund Management Industry

94

Growth of Depository Business

Muhammad Lukman, Chief Executive Officer, National Clearing Company of Pakistan Atif R Bokhari, President & CEO, United Bank Limited Mian Shakeel Aslam, Managing Director and Chief Executive Officer, Lahore Stock Exchange Muhammad Farid Alam, Chief Executive Officer, AKD Securities Limited Basharat Ullah Khan, Chief Investment Officer, Arif Habib Investments Muhammad Hanif Jakhura, Chief Executive Officer, Central Depository Company of Pakistan

SRI LANKA 97

Data Sheet

SOUTH ASIA

SOUTH ASIA: PROFILE OF A GROWTH REGION

Dr Bandi Ram Prasad

President Financial Technologies Knowledge Management Company

Dr Bandi Ram Prasad has over 25 years of professional experience in banking and securities markets and earlier held senior management positions with Indian Banks’ Association, Bombay Stock Exchange, and Dun and Bradstreet (D&B) Information Services India Pvt. Ltd. Consulting experience with Food & Agriculture Organisation of the UN and Asia Pacific Rural & Agricultural Credit Association, Bangkok. Chaired a forum on India’s Service Sector in the World Knowledge Forum held in Seoul in October 2006. Coordinated and organized the India events of the World Federation of Exchanges and South Asia Federation of Exchanges.

While growth is buoyant and financial markets are growing both in size and significance, the South Asia region faces daunting challenges to ensure further momentum in development as also economic and financial stability. An important concern in the South Asian economies is the spectre of inflation that could be a major impediment for economic growth...

The South Asia region gained prominence in the recent period on the back of strong and sustained growth. The region has shown great progress in domestic economic growth as also external strength due to the rapid improvements made in financial markets. Growth and success are evident in overall economic management. In 2011, South Asia is likely show highest growth among all the other regions, except East and South-East Asia. With a likely growth of real GDP at 7.4 percent, economic growth of South Asia is expected to be a clear two percentage points higher than the average of the developing countries and almost two percent higher than that of the Latin American region. The growth process in South Asia has been building over a long period and the quality and sustainability of growth make this region an important destination for international investment. Three of the eight countries in the region—India, Bangladesh and Bhutan—had over five percent growth consistently throughout the decade. Maldives had high growth for several years as also Sri Lanka. The external indicators too have greatly improved. During the 1990-2008 period, external debt as a percent of Gross National Income declined from 31.6 percent to 21.3 percent; debt service to exports from 27.4 percent to 8.4 percent; reserves to external debt stocks rose from 6.5 percent to 84.6 percent; reserves to imports rose from 1.9 months to 6.7 months. In the background of liberalization of the financial flows, short term to external debt stocks during this period rose from 9.8 percent to 15.7 percent, whereas multilateral to external debt stocks declined from 32.4 percent to 27.6 percent. An important outcome of the continued growth is the dramatic decline in the poverty ratio. Though South Asia is likely to continue to be the home of the largest number of people living below poverty line, even ten years ahead, dramatic reductions in the number of people living on less than $1.25 per day were evident in the last two decades. In 1990 more than 50 percent of population in this region was living below the poverty line, which fell to about 40 percent by 2005 and is expected to make a steep climb down to 22.8 percent by the next five years. Higher economic growth, rising opportunities for jobs and income, progress made in the deepening of the financial markets and promotion of financial inclusion are expected to have strong and positive impact in reduction of people living below the poverty line. In the ten-year-period of 2005-15, over 200 million people are estimated to have come out of the poverty line in the South Asia region.

South Asian Financial Markets Review 2010 | 11

Finance and investment have played a major role in economic growth and sustainability of the South Asia region. South Asia showed rapid strides in the development of the financial markets that enabled it to significantly step up investment rates. Between 2000 and 2007, capital inflows into South Asia rose at an average rate of seven percent, next only to that of Europe and the Middle East where capital inflows rose at an average annual rate of 12 percent during the period; stock market capitalization rose at an average annual rate of 107 percent, next only to East and South-East Asia at 118 percent; private credit by banks rose at 14.8 percent, next only to Europe and the Middle East at 15.7 percent; and investment at 8.1 percent, higher among all other regions.

major South Asian countries in 2010 are at higher levels—13 percent for Sri Lanka, 12 percent for Nepal, 10 percent for Pakistan, and 8.4 percent for India—as compared with much more manageable levels found in other Asian countries. Reigning in inflation without affecting economic growth will be a major challenge of macroeconomic policy since many of the countries in South Asia also have higher rates of fiscal deficits. Average fiscal deficit for the South Asia region, which was at 5.7 percent of GDP, is expected to reach 8.6 percent in 2010, and it will marginally decline to 7.8 percent in 2011. For stable growth, containing fiscal deficit and inflation management continue to be major priorities for the South Asian countries. In addition to maintaining macroeconomic stability, both the aspects need to be firmly under control to ensure that poverty levels of people are not adversely affected. About 350 million people in South Asia are still expected to be living below $1.25 per day in 2020. Unless inflation is brought under control and fiscal deficits are greatly reduced, reduction of poverty will be a big challenge.

Deepening of the financial markets was evident from the rapid growth of primary markets, in terms of resource mobilization, and surge in secondary markets, which was reflected through trading volumes. Before the market meltdown in 2008, the South Asia region was an important market for new capital issuance by companies. Trading volumes in exchanges witnessed huge growth on the back of the region emerging as an important destination for the foreign institutional investments. A plethora of products were introduced by the exchanges, including derivatives in commodities, currencies and bonds as also the emergence of exchange-traded funds. The growing interest in the region’s financial markets was evident with Dow Jones coming out with a special SAFE Index, incorporating major stocks traded among the South Asian exchanges.

The importance of developing and further deepening of financial markets could provide an important solution for sustaining growth and development. In South Asia, over 70 percent of the growth in the last two decades came from the financial sector development and it is important to step up this momentum. Financial inclusion has become a major policy imperative for many governments where the challenge is to enhance people’s access to financial services. Simultaneously, harmony and stability in regional politics as well as addressing the issues of civic strife and unrest prevalent in some parts of the region are important areas of focus. Stability and peace could play a pivotal role in promoting economic growth. Forums such as South Asian Capital Markets Conference could contribute to a great extent in this regard by bringing together professionals and practitioners to explore opportunities of mutual interest. Better functioning financial markets could provide greater impetus to domestic economic growth in the region. The next development agenda for South Asia should be designed in this direction.

While growth is buoyant and financial markets are growing both in size and significance, the South Asia region faces daunting challenges to ensure further momentum in development as also economic and financial stability. An important concern in the South Asian economies is the spectre of inflation that could be a major impediment for economic growth. The South Asian countries exhibit higher inflationary conditions as compared to other countries in the Asia region. Inflation rates for South Asian Countries: Real GDP Growth 1991-2014 ( Annual Percent Change) South Asia Countries

Average 1991–2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2014

..

..

..

15.1

8.8

16.1

8.2

12.1

3.4

15.7

8.6

8.9

4.9

4.8

4.8

5.8

6.1

6.3

6.5

6.3

6

5.4

5.4

6.5

5

6.8

10.9

7.2

6.8

6.5

6.3

21.4

7.6

8.5

5.3

6.8

India

5.6

3.9

4.6

6.9

7.9

9.2

9.8

9.4

7.3

5.4

6.4

8.1

Maldives

7.5

0.1

6.5

8.5

9.5

-4.6

18

7.2

5.8

-4

3.4

4.2

5

-0.2

0.1

3.9

4.7

3.1

3.7

3.2

4.7

4

4.1

5.5

Pakistan

3.9

4.4

3.2

4.9

7.4

7.7

6.1

5.6

2

2

3

5.5

Sri Lanka

5.2

-1.5

4

5.9

5.4

6.2

7.7

6.8

6

3

5

5.4

Afghanistan, I.R. of . . . . Bangladesh Bhutan

Nepal

Source : World Economic Outlook, International Monetary Fund

SOUTH ASIA

oVERVIEW: ECONOMY, FINANCE & MARKETS Some of the COMMON THREADS • • • • • •

Services industry plays a greater role in economic development Domestic demand, though softened during the crisis, was more buoyant than other regions Lower scope for fiscal manoevrability— fiscal imbalance Weak resource mobilization structures—abysmally low tax/GDP ratio Higher subsidy and interest payments as a percentage of government expenditure Infrastructure bottlenecks

Like any other regional grouping, South Asia has its unique common thread that binds the economies together. The region’s distinct culture and history, oft-mentioned themes, are recognized as motivators that allow and strengthen such a grouping. However, within the region, the famous ‘South Asia diversity’ raises its head and reiterates that there is serious amount of work left. At one end of the spectrum, the region has economies that are re-establishing the basics, like Afghanistan, and, in contrast, at the other end there is India, with all the trappings of a modern economic dynamo. With India accounting for over three-fourths of the region’s GDP, some of the emerging trends might appear skewed. South Asia, as a region, has gained in significance in the world standing in the past decade by recording impressive growth (averaging six percent a year since 2000, translating into strong fundamentals and stronger economies). The region as a whole has registered over eight percent annual growth in GDP for a couple of years up to 2007. With economic contagion setting across the globe following the global financial crisis, the South Asia economy has also not emerged unscathed, although it has weathered the crisis better than other regions. While growth continued, it has moderated to six percent in 2009, this in times when the global economy contracted by two percent. The negative impact of the crisis was least pronounced for the region as compared to other developing groups, also reflecting the closed nature of the economies. The crisis was reflected by the plunging currencies, moderating remittance inflows that account for a significant share of GDP (over five percent of GDP in Bangladesh, Nepal and Sri Lanka), easing monetary stance by way of falling interest rates, declining asset prices, dampened investor sentiment, and private capital outflows. The region experienced sizeable capital outflows at the onset of the crisis, particularly in Pakistan and Sri Lanka, where outflows were driven by investor concerns about rising domestic and external imbalances. The flow of private capital, key transmitting channel of this round of crisis, is less significant as a share of South Asia’s GDP compared to the other economic regions. With a slowdown in industrial activity and domestic demand, there was also a sharp contraction (39 percent) in imports of the region, especially for Maldives, Pakistan and Sri Lanka (Maldives relies heavily on imports for meeting basic needs). Bhutan also had to bear the brunt with current account deficit rising to 12.3 percent of GDP in 2009 from 10 percent in 2008. In contrast, the export segment proved more robust, with Bangladesh and Sri Lanka

even recording increase in demand for their largest export item, readymade garments. Competitive pricing and agreements with large retailers in the US and Europe have buffered their economy. A major fallout of the crisis was increased unemployment of expatriate workers in the Middle East and South East Asia, resulting in a decline of remittances into the region. In India, the largest recipient of remittances the world over, remittance inflows contracted, while in Nepal, Bangladesh, and Pakistan they slowed in the pace of growth. Pakistan, Maldives, Sri Lankan economies had to be supported by the IMF’s stabilization programmes. The brakes to a wholesale decline were the strength of the domestic activity and private consumption, which showed marked resilience. In response to the crisis, South Asia announced decisive measures to support local demand. At the cost of bourgeoning fiscal imbalances, the South Asian economies announced substantial fiscal stimulus measures in an attempt to tide over the crisis. The fiscal stimulus measures have largely been successful in reviving consumer demand. Success of this slippage on fiscal control is expected to manifest with growth expected to be six percent in 2010 and 7.4 percent in 2011. Once again the pace of growth and recovery would vary across the region. Bangladesh, Bhutan, and India will emerge strong and sounder growth economies with sound policies, stronger investment, and private capital inflows. Bangladesh, Nepal, Sri Lanka, and Pakistan will benefit from increased remittances that will boost private consumption. Investor confidence in Sri Lanka is already improved following the end of the conflict. Pakistan and Nepal are expected to face moderate growth. Downside risks remain and will depend upon the extent of recovery as also the pace of recovery and the sustainability of the recovery. Gradually, in 2010, as the scenario unfolds, a more positive outlook will emerge for the region. The rapid growth of economy and finance in India, the potential of growth in Pakistan, the peace dividend in Sri Lanka, the inclusive growth approach of Bangladesh, and the prospects of growth in Bhutan, Nepal and Maldives make great prospects for the South Asian region and holds promise for the international investing community.


Bangladesh

Bangladesh’s economy has maintained an even keel and weathered the crisis rather well. The country’s GDP grew at an average rate 5.8 percent per annum during 2000-2009 and the annual growth rate only contracted to 5.9 percent in FY2009, down from 6.2 percent in FY2008. The overall structure of the economy had significant changes, resulting in shrinking of the share of the agriculture sector in the economy to 20 percent to the benefit of the services sector. The export of readymade garments, which accounts for 75 percent of total exports and posted a robust growth during the crisis, has emerged as a driver of economic growth. Bangladesh is relatively insular to the global crisis with domestic demand accounting for 107 percent of GDP acting as a major shock absorber. The taka proved to be a stable currency against the dollar on the back of inflows from remittances, which grew by 23 percent in 2008-09.

Nominal Exchange Rate 75 65 55 45 Sep-00

Sep-01

Sep-02

Sep-03

Sep-04

Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Source: Bangladesh Bank

However, downside risk continues to persist. • The banking segment is vulnerable, with a high NPA rate of 13 percent in 2007, although down from a high of 41 percent in 1999. • Further, low industrial activity has led to a contraction in loan disbursement. • Export concentration on readymade garments could also cause concern, going forward. The export base needs to be broadened. • Tax base is narrow while infrastructure needs are tremendous. • FII investment saw an outflow of $160 million in 2008-09 from a surplus of $50 million in 2007-08. • Markets fell from a peak of 3147 in May 2008 (DSE index) to a low of 2433 to make a new peak at 4393 in December 2009.

Sri Lanka

The going was rough for Sri Lanka in 2008-09. The most direct effect of the global economic turmoil, apart from sharply contracting GDP growth, was on the trade deficit with slowing export demand (export of readymade garments grew by only five percent) and high global prices. The forex reserves bottomed out at $2.65 billion in the first quarter of 2009 from a high of $5 billion in July 2008 and the government had to seek an aid package of $2.6 billion from the IMF in the middle of 2009. The IMF loan and the end of civil war have brightened the prospects, leading to optimism and improved sentiment in the economy. Although the tourism segment will take some time to recover to pre-war growth levels, there are signs of recovery.

Real GDP Growth % 8 6 4 2 0 2003q1

2004q1

2005q1

2006q1

2007q1

2008q1

2009q1

With these positive developments by end-September 2009 , BOP recorded a surplus of $2.2 billion and the gross official reserves (excluding ACU receipts) exceeded $ 4.2 billion. These developments resulted in the rating agencies, Standard & Poor’s (S&P) and Fitch upgrading the sovereign rating outlook to ‘positive’ and ‘stable’, respectively. The second international bond of $500 million issued in October 2009 was oversubscribed by more than 13 times indicating clearly the heightened confidence of investors globally. The Sri Lankan economy is projected to recover in 2010 with a growth rate of around six per cent, while growth is projected to be broad-based with a positive contribution being made by all the major sectors of the economy.

Nepal

Nepal is another country whose economy is deeply linked to the prospects of the Indian economy. The Nepalese rupee continues to be pegged to the Indian rupee. The economy underwent a structural change in the last decade and the share of services sector has surged to contribute a little over half of GDP. Consequent to a relatively insular financial sector, the economy remained fairly resilient in the face of the crisis with GDP moderating only slightly. Remittance inflows have as yet remained strong, registering a growth of nearly 50 percent in 2008-09 over a 42.5 percent growth in the previous year. Going forward, there may be a slowdown given the lag effect that plays in the cycle and growing unemployment abroad.

Bhutan

Bhutan is one of the smallest economies in the world, closely aligned with India by its strong trade and monetary links. The Bhutanese currency, Ngultrum, is pegged to the Indian rupee. Tourism, steel, and power exports to India are key drivers of growth. The global recession has impacted Bhutan’s economy only through its links with India. Following a fall in demand of steel in India, steel production in Bhutan contracted. The fiscal deficit widened to 6.9 percent of GDP in 2009-10 from less than three percent of GDP in 2008/09. This was largely due to an upsurge in the current spending due to higher wage bills and social security contributions of the government and interest payments. The government had to resort to external borrowings, mainly from the World Bank and ADB, and had to rely on grants from India. In future, Bhutan will continue to reap the benefits of hydropower exports to India, which will drive the economy. However, its reliance on India for economic growth is a risk.

Maldives

Tourist Arrivals and Arrival Growth, 2001-2011

%change

‘000s

The Maldives comprises 1191 islands, of which only 200 are 60 800 inhabited. The island’s economy is powered by the tourism and 50 700 40 fishing industry. Tourism and services contributed to more than 600 30 a quarter of the GDP and more than 60 percent of forex receipts. 20 500 The economy has made remarkable recovery after the tsunami. 10 400 Development has been centered on tourism and service sectors 0 300 -10 like transport, real estate, and construction. -20 200 -30 100 However, the slowdown in the global economy has translated -40 -50 into a slowdown in tourist arrivals to the Maldives. The Maldives 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 economy took a big hit during the crisis with widening Proj Proj Proj imbalances as current account deficit increased to 45.5 percent Tourist Arrivals Growth in tourist arrivals (in percent) in 2009. Public debt increased from around 40 percent of GDP in 1999 to around 57 percent in 2008, raising sustainability concerns. The fiscal balance also deteriorated to 15.7 percent of GDP in 2008 from 7.9 percent in 2007. The IMF and ADB intervened and approved a stand-by arrangement of $92.5 million with the government in December 2009.

Pakistan

Pakistan’s economic fundamentals continue to be a concern with GDP growth projected to be 2.5 percent in FY10, marginally up from the two percent in FY09. The economy is dogged by both weak domestic and external demand and deteriorating security environment. Further, the central bank has revised its CPI forecast for FY10 upwards to12 percent from the earlier projected nine percent. Private credit contracted by five percent during the first three quarters of 2009 as banks turned risk averse with higher NPLs (3.7 percent in June 2009 from 1.1 percent in 2007). A forex crisis was averted by the support of the IMF. Reacting to these negative trends, the stock markets declined by 60 percent in the six months to 2009. They have now recovered along with world markets, surging 70 percent over January 2009 levels. There are also initial signs of recovery of the economy with encouraging investment and consumption numbers. In 2009, the Pakistan currency depreciated by only over five percent as against a 28 percent fall in 2008.

INDIA

FY 10 was a difficult year for Indian economy. GDP growth in the last two quarters of FY09 had slowed down to six percent and there were fears that this trend could continue. Yet, over the span of the year, the economy posted a remarkable recovery, not only in terms of overall growth but, more importantly, in terms of major economic fundamentals, which justify optimism in the Indian economy in the medium to long term. The real turnaround came in the second quarter of 2009-10 when the economy grew by 7.9 per cent. A major concern during the FY10, especially in the second half, was the emergence of high double-digit food inflation which touched 19.8 percent in December 2009. Demand for bank credit/non-food credit also remained muted during the year.


The equity markets are perhaps one of the few metrics that have provided a measurable barometer for the devastation that the global economic crisis has wrought on the financial world. The crisis has brought forth an extremely challenging environment for the markets. Deterioration in risk appetite of the investor community in late 2007 and whole of 2008 left no market avenue unscathed. The enormous deleveraging and adverse conditions took its toll on the markets. Driven by the weakness in the markets, the landscape of the industry was significantly altered. While most local stock exchanges have recovered to pre-crisis levels the majority remain well below peak levels.

Common Threads

• • • • • • •

Reforms in the financial markets Financial sector is dominated by the banking industry Markets lack depth and are volatile, at various degrees Low investor base across the region Concentration of market cap in the top 10 companies is high Relatively closed economies acted as a buffer to the crisis—private capital inflows are less significant Indian financial markets lead the region in terms of products offered, maturity, regulatory standards, participation, etc.

Mauritius

• • • •

A small market that has achieved impressive growth. The market cap since inception to end-2009 has increased by over 100 percent. Market cap to GDP currently stands at close to 75 percent as against 2.5 percent in 1990. FIIs play a significant role in the market, accounting for 40 percent of the trading volume. Emergence of a new player, GBOT, with plans to offer multi-asset class trading platform.

Bangladesh

• • •

Market participation is dominated by retail investors and domestic institutional participation. Market cap to GDP is low at 30 percent by end-2009. Domestic investors exceed 2.5 million.

benchmark index KSE 100 also fell sharply and regained some portion of the loss. The weak sentiment prevailing at the time resulted in massive redemptions hitting the mutual fund industry, which halved from April 2008 to January 2009. The mutual fund industry is still struggling to find its feet and attract investors back. AUMs have increased by just over 20 percent till end-2009. Apart from India, Pakistan is the only country in the region that has a well-regulated, well-established financial market with multi-asset class being offered and actively traded.

Sri Lanka • • •

Bhutan

• •

The capital market is yet to develop and the investment culture has not been inculcated. Total number of shareholders is less than three percent of the population. Four state-owned institutions dominate the trading activity and act as intermediaries.

Maldives

A very fledging capital market, which the regulator needs to develop further. Maldives is being developed as a major financial center with the Government coming out with a Capital Market Strategic Plan covering a five year period 2010-14. The Strategic Plan envisages development of capital market infrastructure, institutions and intermediaries.

Nepal

• • •

The culture of financial markets as an avenue of saving is yet to set in. Liquidity is low. The mutual fund industry has not yet established roots and participation in equity markets is restricted to direct investments, especially in primary markets. There are 23 brokers registered with the regulator servicing close to 1.2 million clients.

• • • • •

India • • • •

•

Pakistan

Underscoring the volatility in the markets, market capitalization that reached a peak in 2007 declined 60 percent in 2008 and then recovered nearly 50 percent of the value by early 2010. During the same period, the

Equity prices have surged. All-Share Price Index rose nearly 100 percent at end-October 2009. The bullish sentiment was contributed to by numerous factors: positive investor sentiment following end of hostilities, sharp decline in inflation, lower interest rates and an IMF stand-by arrangement. The recovery was driven by domestic investors who account for 72 percent of the transactions. FIIs do not play a major role in the market. Around 60 percent of the shares are demated. PE ratio rose to 14.4 in October 2009 from 5.4 in December 2008. Market cap more than doubled in the same period.

•

A well-developed financial sector. Capital markets are dominated by equity and debt markets. Derivative trading has showed spectacular growth. The market cap to GDP has risen from 30 percent in 2001 to over 100 percent in 2009. During the crisis, this ratio had declined to 60 percent. Mutual funds faced heavy redemption pressure through the crisis. AUMs of the MF industry account for less than 15 percent of GDP as compared to 70 percent in the US, 61 percent in France and 37 percent in Brazil. Multi-asset class offered with the introduction of commodities and currencies derivative trading on the exchanges, which offer currency trading in four currency pairs. MCX Stock Exchange emerged as the leader in trading of exchange-traded currency futures. MCX is the sixth largest commodity futures exchange in the world. G-Secs market is relatively well developed as against corporate bond market, which lacks depth.

BANGLADESH

Central Depository Bangladesh Ltd Chittagong Stock Exchange Ltd Dhaka Stock Exchange Ltd

Exchange Industry

Other Asset Classes

Exchanges Stock

Number

2

Commodity

Number

Proposed

Currency Markets (Exchange-traded)

N/A

Commodity Markets

Proposed

Banking Capital Markets

Regulator

Name

Bangladesh Bank

Scheduled Commercial Banks

Number

48

Regulator

Name

Securities & Exchange Commission

Brokers

Number

143

Registrars

Number

1

Custodians

Number

9

FIIs

Number

22

Merchant Bankers

Number

31

Venture Capital Funds

Number

1

Depositories

Number

1

Demat Accounts /active BO A/C

Number

23,85,170

Companies Listed

Number

415

Market Capitalization (Dec 31, 2009)

$ mn

21,011.53

Mutual Fund Industry

Growth in Market Cap (Dec 31, 2009 / Dec 31, 2008)

%

82.06

Regulator

Name

Securities & Exchange Commission

Concentration (Top 10 companies by total Mcap)

%

39.85

Fund Houses

Number

7

Turnover (2009)

$ mn

2314.56

Growth in Turnover (2009 / 2008)

%

60.82

Liquidity (Mkt cap/GDP)

%

23.92

PE Ratio

Dec 31, 2009

24.85

Products Offered

Equities, Mutual Funds, Corporate Bonds

Public Sector

Number

9

Private Sector

Number

23

Foreign

Number

9

Islamic

Number

7

Credit/Deposit Ratio

%

75

Capital Adequacy Ratio (2009)

11.68

Benchmark Interest Rate

%

5

Prime Lending Rate

%

12.31

Bank Assets to GDP

%

62

BANGLADESH

Importance of Knowledge Based Economy in South Asian Countries Fakhor Uddin Ali Ahmed President Chittagong Stock Exchange

Fakhor Uddin Ali Ahmed was serving as Director of Chittagong Stock Exchange (CSE) since 2000 before becoming the President. Mr Ahmed is the Chairman of a leading CSE member firm, International Securities Company Ltd. He is involved with many other businesses in areas such as textile and information technology. He is the Chairman of Sylhet Communication System, SOS BD Ltd., FD Consortium Ltd., and Taizin Taxtile Ltd. He is the senate member of Shahjalal University of Science and Technology. He was also the President of Sylhet Chamber of Commerce and Industry in 1997. Mr Ahmed holds BCom (Hons) and MCom from the University of Chittagong. He is a social activist, contributing a lot to the activities of Red Cresent, Sylhet Heart Foundation, Rotary International, Sylhet Education Foundation, etc.

The successful transition to the Knowledge Economy typically involves elements such as long-term investments in education, developing innovation capability, modernizing the information infrastructure, and having an economic environment that is conducive to market transactions...

Introduction

In the past decade or so, much research has been conducted on productivity-led economic growth and its determinants. A major reason is the widespread belief that economic growth due to rapid factor accumulation is subject to diminishing returns, and hence is not sustainable. Recently, there has been a growing interest in the contribution of knowledge to total factor productivity growth, and consequently to sustainable long-term economic development. This paper highlights the importance of the use and creation of knowledge for long-term economic growth. It discusses the concept of the knowledge economy, which is essentially an economy where knowledge is the main engine of economic growth.

Knowledge Revolution and Global Competition

Over the past quarter century, the rate of knowledge creation and dissemination has increased significantly. One reason is the rapid advances in information and communication technologies that have significantly decreased the costs of computing power and electronic networking. With the increased affordability, the usage of computing power and electronic networking has surged, along with the efficient dissemination of existing knowledge. Modern information and communication technologies also enable researchers in different locations to work together, which consequently enhance the productivity of researchers, resulting in rapid advances in research and development and the generation of new knowledge and technologies. International organizations like the World Bank have spent $220 million for corporate networking and regional knowledge sharing activities and $60 million for three global knowledge initiatives: the Development Gateway, Global Development Learning Network (GDLN), and Global Development Network (GDN). These programmes have initiated a lot of innovation, with potentially significant benefits for the scaling up of effective bank interventions and for empowering clients to improve development outcomes (Source: Sharing Knowledge, The World Bank Report 2003).

The Knowledge Economy

With sustained use and creation of knowledge at the centre of the economic development process, an economy essentially becomes a knowledge economy. A Knowledge Economy is one that utilizes knowledge as the key engine of economic growth. It is an economy where knowledge is acquired, created, disseminated, and used effectively to enhance



economic development. It has been found that the successful transition to the Knowledge Economy typically involves elements such as longterm investments in education, developing innovation capability, modernizing the information infrastructure, and having an economic environment that is conducive to market transactions. These elements have been termed by the World Bank as the pillars of the Knowledge Economy. Three kinds of knowledge activity are considered: knowledge generation, transmission, and use (Foray and David 1995).

The Importance of Geography

Geography is an issue even in a global economy as firms relate to their competitors, local institutions of education, and affiliate firms that may be geographically close if the firm is a spin-off. While there is a considerable literature on clusters and other graphical characteristics (OECD 2001, Florida 2002), stimulated by the work of Porter (1990), statistical organizations and academics are still working on indictors that could provide reproducible evidence of the existence and performance of a cluster.

Uneven Development of Knowledge Management across Asia

A few Asian countries have adopted a national strategy or a national policy towards a knowledge-based economy or knowledge-based development. Government policies on knowledge-based economy or knowledge-based development can push forward the development of knowledge management in that country. So far only Japan, India, Republic of Korea, Malaysia, Thailand, and Singapore have adopted a national knowledge management strategy. In the South Asia region, India has started in full swing while Bangladesh and Pakistan just started and rest of the countries are still going very slow.

Strength of Knowledge Management in Some Asian Countries

India is the leader in developing support systems for knowledge management in information and communication technologies. India has a national Knowledge Commission and it has a governance model on how to move towards becoming a knowledge-based economy. Knowledge management is extensively practised in the Republic of Korea. Pakistan has just initiated a knowledge-based economy. Knowledge management is widely accepted in China and it has very good support systems for information and communication technologies. Malaysia exemplifies support from a national leader. It is very interesting

that Thailand issued a royal decree a few years ago that requires all government agencies to take up knowledge management and become learning organizations. Thailand has set up an office for knowledge management and development. Vietnam has a government-led initiative to transform itself into a knowledge-based economy with knowledgebased development.

Developing a Knowledge-Based Economy

Knowledge is complex and is growing in complexity (Hodgson 2000), especially the measurement of knowledge, assuming that measurement is possible. A knowledge-based economy is developed by organizing knowledge interactions with information technology, business strategy, and changing social and economic conditions. Knowledge management can result in economic or social outcomes, and then the focus can be on economic effects (Stehr 1996). Numerous researchers have evaluated how distributed models of innovation and learning are empowering users and challenging education, research, and commerce. They examined the emergence of software, the Internet, and cyber infrastructure as enablers of knowledge processes and as scaffolding for producing and using new tools and representations of knowledge. They will consider how the management and regulation of knowledge differs from the treatment of tangible inputs in terms of principles, trade-offs, and policy models.

Conclusion

This is a very opportune time for the South Asian Countries to make its transition into the knowledge economy; an economy that creates, disseminates, and uses knowledge to enhance its growth and development. The knowledge economy is often taken to mean only high-technology industries or information and communication technologies. It would be more appropriate to use the concept more broadly to cover how all economies harness and use new and exciting knowledge to improve productivity of agriculture, industry and services and increase overall welfare of society. In South Asia, great potential exists to increase productivity by shifting labour from low-productivity and subsistence activities in agriculture, informal industries and services to more productive modern sectors and knowledge-based activities to reduce poverty. South Asia should continue to leverage its strengths to become a leader in knowledge creation and use. To get maximum benefits from the knowledge revolution, the country needs to press on with its economic reform agenda, which was put into motion more than a decade ago, and continue to implement the various policies and institutional changes required to accelerate growth.

BANGLADESH

A close-up of the Markets

Wali-ul-Maroof Matin Chairman & Managing Director Alliance Capital Asset Management Ltd

The image of Bangladesh is changing and the world has started to believe that the country is an emerging Asian tiger. The leading global investment banks—Citi group, Goldman Sachs, JP Morgan, and Merrill Lynch—have all identified Bangladesh as a key investment destination...

Under the shadows of large economies in South Asia, i.e., India and Pakistan, other South Asian markets often fade out from the radar of international investors. Though perceived by many as small, Bangladesh is an economy of over 16 million people. It is true that the population under poverty line is quite large, but the middle class and upper middle class with sufficient purchasing power are also significant. The people with annual income of $40,000 will outnumber the population of Malaysia or Singapore. One year ago, NTT DoCoMo paid $350 million to acquire 30 percent of the third largest mobile telecom operator, AKTel, in Bangladesh, thereby valuing the company over $1 billion. This suggests that although it is not widely focused by the global press, Bangladesh has made a steady growth over the last decade, but a very few global astute investors are testing the vibes of the Bangladesh market. The image of Bangladesh is changing and the world has started to believe that the country is an emerging Asian tiger. The leading global investment banks—Citi group, Goldman Sachs, JP Morgan, and Merrill Lynch—have all identified Bangladesh as a key investment destination. Goldman Sachs put Bangladesh in its ‘Next Eleven’—a group of nations having promising economic growth potential to watch. Also, JP Morgan included Bangladesh in its ‘Frontier Five’ group of countries along with Kazakhstan, Kenya, Nigeria, and Vietnam.

Dhaka Stock Exchange Indicators

TK billion

Wali-ul-Maroof Matin has a unique perspective of the capital markets in South Asia. He was the founding Secretary General of South Asian Federation of Exchanges, CEO of Chittagong Stock Exchange, and the Resident Consultant of Bank of Sierra Leone for Capital Markets Development. The development of capital market institutions and systems modules for legal and ethically correct trading is his speciality. His name figures in the SEC list of ‘Well-known Eminent Consultants’ of Bangladesh. Mr Matin was part of the team that played a key role in drafting many rules and regulations of the Bangladesh capital market in the post-1996 period. He is a graduate in Economics from Dhaka University and did his MSc in Accounting and Management Science from Southampton University, UK. He obtained PG Diploma in Managerial Control and MIS from Maastricht School of Management, the Netherlands.

2,000

4,500

1,800

4,000

1,600

3,500

1,400

3,000

1,200

2,500

1,000

2,000

800

1,500

600 400

1,000

200

500 0

0 Jan-07 General Index (27 Nov 2001 = 817.62)

Jan-08 Jan-09 Total Market capitalization (Tk billion)



The above observations were publicized well before the so called credit crunch. Interestingly, the scenario cannot be changed very much over the slow years as the Bangladesh market enjoyed an undue favour from cross-border investors. It is often said that Bangladesh is an insulated market. Only three percent of market capital is owned by foreign investors despite a large scope. A large number of Bangladeshis are living abroad. That is a major window for foreign currency to reach the Bangladesh market. A significant portion of national earning is coming from foreign remittance, which was calculated at $9,689.26 million in FY 2008-09, 22.42 percent higher than the previous fiscal year. Otherwise, it is mostly internal money circulating in the capital market from other formal and informal sectors. It is natural that a fast-growing system (the Bangladesh market is the fastest growing market after that of China) will suffer from growth pains. As of now, the markets here suffer from lack of product diversity, mass awareness, liquidity, and international standards of governance. If we do not talk about the lacunae, although short, this write up will be one-sided. To talk about product diversity, it is basically an equity market. There are 437 listed securities, of which 250 are actively traded. Interestingly, there are 151 T-Bonds and only two corporate bonds, which are not at all traded. Total market cap, as of end-March 2010 stands at $33,178 million. There are 44 companies in the Insurance sector alone.

However, the Banking sector has the largest market capital—30 percent of the total market cap. More that 80 percent of the people are Muslim, it is often discussed that Islamic funds may find ground in Bangladesh. Islamic Banking bloomed here but so far there is only one Islamic Mutual fund in the market. There are 24 mutual funds, of which Investment Corporation of Bangladesh (ICB) alone manages 16. All of them are close-ended funds that are operating in the capital market. There are a couple of openended mutual funds and the technique of listing open-ended mutual funds is yet to be engaged. Private mutual funds are new but they are taking ground quickly. Recent trend in Index is upward, as shown in the graph. Some analysts suggest that it cannot be sustainable as it is not matching with the national economic growth. There are two exchanges: Dhaka Stock Exchange and Chittagong Stock Exchange. The Exchanges are not demutualized yet. These Exchanges are self regulatory. Large governing boards (25 members) consist of 12 brokers and 12 selected individuals. The CEO is a non-voting member of the Board. Good governance remains an issue. But through the usual (and some unusual) oscillation the Bangladesh market will continue to play its role in general economic development.

Best Compliments

BANGLADESH

BANGLADESH ON GROWTH PATH

Annisul Huq

President Federation of Bangladesh Chamber of Commerce and Industries

Annisul Huq is a well-known business entrepreneur in Bangladesh. Founder of the Mohammadi Group, Mr Haq has served on the board of Bangladesh Garment Manufacturers Association (BGMEA) for over a decade. He has also served as the President and Vice President of BGMEA over different terms. Currently, Mr Huq is the President of Federation of Bangladesh Chamber of Commerce and Industries (FBCCI), the apex trade body in Bangladesh. The Mohammadi Group produces woven garments and sweaters. Its customers include H&M, C&A, Zara, Esprit, Sears, Wal-Mart, and Target Stores. The Group is involved in real estate business and also owns a software and IT services company in Bangladesh.

When the Global Financial Crisis 2008 dealt a severe blow to the economies of most of the developed countries and impacted the economies of developing and underdeveloped countries, Bangladesh showed economic resilience, continuing with its image of a sustainable economy...

Bangladesh aspires to achieve the status of a middle income country by 2021. With that focus set, the country has been striving to outperform and create an investment climate in the region. In order to achieve this target, the policy makers need to be in complete sync with commerce. Many corporate institutions are getting listed on the bourses. Since the securities market demands discipline in the institution’s mechanism and strategic process of accountability and transparency, the business houses allow visibility and automatically become more viable. While meeting the mandatory disclosures such as quarterly and half-yearly unaudited financial statements, yearly audited statements, and other timely disclosures as required by the concerned regulators, the corporate institutions have been performing comparatively better. Sectors like banking and non-banking financial institutions, cement, pharmaceuticals, textile, engineering, information technology, communications, and insurance have been auguring well. Observing the price to earnings ratio, net profit after tax, growth pattern, contribution towards building the national economy and other relevant factors, it seems that our corporate bodies have been performing better. We can easily assess the extent of performance of corporate institutions in Bangladesh by taking a look at dividends that were doled out. In 2009, dividend of the Banking sector stood at 23.76 percent, Investment 24.26 percent, Engineering 20.65 percent, Food and Allied Services 17.13 percent, Fuel and Power 36.67 percent, Jute 11.67 percent, Textile 8.81 percent, Pharmaceuticals 40.68 percent, Paper and Printing 12.50 percent, Service and Real Estate 20.64 percent, Cement 8.29 percent, IT 9.90 percent, Tannery 55.20 percent, Ceramics 13.75 percent, and Insurance 19.60 percent. These statistics clearly stand for the robust performance of corporates in Bangladesh.

Bangladesh, the Investment Frontier: Goldman Sachs & Bloomberg

The country offers the opportunity of 100 percent profit repatriation facility in most of the sectors, which are completely open for private or joint ownership, domestic or foreign. Foreign investment is totally secured by the Investment Act. Besides these, reduced cost of doing business, availability of skilled and semi-skilled labour at a cheaper cost, and many other factors help attract Foreign Direct Investment (FDI). Bangladesh is the safest destination for foreign investors in the South Asian region. Over the years, FDI inflow into different sectors of the Bangladesh economy has risen considerably, proving that Bangladesh is the immaculate hub for foreign investors. More importantly, when the Global Financial Crisis 2008 dealt a severe blow to the economies



of most of the developed countries and impacted the economies of developing and under-developed countries, Bangladesh showed economic resilience, continuing with its image of a sustainable economy. The country has been the most lucrative destination for foreign investors. FDI in FY 2004-05 was $776.00 million, 2005-06 $743 million, 2006-07 $793.00 million, 2007-08 $650.00 million, and in 2008-09 $941 million. In FY 2009-10, the FDI inflow into Bangladesh has reduced significantly; it was $259 million till November 2009. Bangladesh needs to correct the scenario by focusing on infrastructural development, including power, roads and highways development, sophisticated port facilities, reduction of business operation cost and simplification of business commencement procedures. On the other hand, foreign trade turnover in the country’s prime bourse has been Tk 41.96 crores in 2004-05, Tk 68.56 crores in 2005-06, Tk 989.53 crores in 2006-07, Tk 1,922.42 crores in 2007-08, Tk 1,183.92 crores in 2008-09 and Tk 1,077.79 crores in 2009-10 (till February 2010).

Corporates in the Capital Market

The country’s capital market has been growing at a stable rate over the last six years. Its growth can be demonstrated from the growth of market capitalization ratio (GDP to market value of listed securities) from less than 3 percent in 2003 to 30 percent by the end of 2009. Such steady growth was not been swayed away by the global financial crisis as more than 2.5 million domestic investors from all around the country as well as different countries of the world (NRBs) are increasingly becoming the investors in the market. As mentioned above, the capital market of Bangladesh has demonstrated a steady growth pattern during the last five years and the current scenario indicates the continuation of past trends of success. The table below shows that from December 2004 till December 2008 the market capitalization has increased by more than 400 percent in a steady manner. Growth of Market Capitalization in Bangladesh from 2004 to 2008 Year

M Cap (Tk.mn)

M Cap ($ mn)

2004

224,159.21

3,248.68

2005

228,574.85

3,312.68

2006

315,446.21

4,571.68

2007

742,195.87

10,756.46

2008

1,043,799.02

15,127.52

2009

1,884,493.03

27,244.23

Source: Dhaka Stock Exchange

Mandatory regulatory provisions practised by many organizations such as banks and financial institutions have forced these institutions to offload shares in the market. Apart from the congenial regulatory strategies such as Direct Listing Regulations, 2006, newly introduced Book Building Method, and time-bound co-operation in the form of concerted and comprehensive actions by regulatory bodies are now pushing corporate entities to float shares in the capital market. In 2009, 19 companies were listed with the Dhaka Stock Exchange (DSE) and they raised Tk 8,917.25 million from the country’s capital market. A multinational company like Grameenphone Limited has come up with an Initial Public Offering (listed on November 16, 2009) worth over Tk 486 crores and pre-IPO placement of a similar amount (in December 2008). Newer players like RAK Ceramics are anxious to enter the Bangladeshi market as no other land offers such transparency and returns. The export earnings, GDP growth, remittance flow, stability of Taka against major currencies, steady stock markets (less than 14 percent index fall against 40 to 60 percent fall in almost all stock markets in the world), growing balance of foreign currency reserve, etc. indicate the inner strength of the economy of the country. Bangladesh has never defaulted in its internal or external debt-service liabilities. It has successfully controlled its population boom and has grown up to 33 million metric tonnes of food grains, which is marginally enough to feed its 150 million people. Moreover, Bangladesh represents a positive image in the eyes of the world. It has never experienced negative economic growth since Independence and has successfully mobilized domestic resources at increasing rate; currently financing more than 89 percent of its total budget from internal resources. Import tariff, too, is one of the lowest in the entire South Asia region. The driving forces behind the good economic performance are favourable economic policy, strong domestic demand spurred by remittance inflows, the central bank’s proactive monetary policy and investors’ confidence in the capital market. All these factors are contributing to a stronger market-force-driven economy where the corporate enterprises, not the public sector enterprises, play the lead role for the next-generation economic development of Bangladesh. Though Bangladesh is a small investment market, it deserves significant positive appreciation.

BANGLADESH

Emerging Trends in the Capital Markets

Mohammed Nasir Uddin Chowdhury Chief Executive Officer and Director LankaBangla Securities Limited

LankaBangla Securities Limited is one of the largest stock broking companies in Bangladesh. With more than 14 years of experience in the financial sector, Mr Chowdhury has worked with many of the industry’s leading companies. Under his leadership, LankaBangla reached the top position in Dhaka Stock Exchange as well as Chittagong Stock Exchange. He is also serving as a Director of DSE and MIDAS Financing Limited as well.

The Bangladesh stock market has been growing rapidly and currently constitutes about 30.95 percent of the country’s gross domestic product (GDP) as of December 31, 2009 against only 5.49 percent in 2005...

Mr Chowdhury holds a masters degree in Marketing from University of Chittagong and a degree in Law. He has written many articles related to finance, especially capital markets, and is a speaker at industry-specific seminars as well as academic events.

An Overview of Bangladesh Stock Market

The stock market in Bangladesh consists of two exchanges: the Dhaka Stock Exchange (DSE) and the Chittagong Stock Exchange (CSE). Both the stock exchanges function under the purview of related regulations of the Securities Exchange Commission (SEC). The SEC has issued licences to 31 institutions to act in the capital market. Of these, 29 institutions are full-fledged merchant bankers and portfolio managers while one acts as portfolio manager and another as issue manager. There are 238 stock brokers in DSE and 143 in CSE.

Sector-wise Market Capitalization (January 31, 2010)

% 35

Pharmaceuticals & Chemicals 7%

Bank, NBFI 24%

30 Other 27%

Fuel & Power 10%

Market Capitalization to GDP Ratio

25 20 15 10 5

Telecommunication 16%

Treasury Bond & Corporate Bond 16%

Emerging Trends

0

2005

2006

2007

2008

2009

The DGEN index on the Dhaka Stock Exchange has grown at an impressive CAGR of 28.23 percent from 2005 to 2009, including a 62.25 percent growth in the last calendar year, making it one of the best performing markets in the world. Turnover levels in the market has improved significantly with average daily market turnover increasing from BDT 2.76 billion ($40.12 million) per day in 2008 to BDT 6.05 billion ($87.31 million) per day in 2009. Trading activity at DSE has seen a strong and sustained growth momentum over the last few years, with several new IPOs. The market continues to be dominated by active local retail participation along with strong domestic institutional participation, primarily being local commercial and merchant banks, and foreign institutional investors.



Performance of DSE from 2005 to 2009

DGEN Index vs Turnover

2006

2007

2008

2009

5000

No. of Securities

286

310

350

412

415

4500

No. of Equity Securities

260

268

281

292

255

4000

Mkt. Cap ($ bn)

3.52

4.67

10.82

14.06

26.96

3500

6.20%

7.70%

17.50%

20.80%

30.95%

3000

3.80

4.82

19.86

40.12

87.31

2500

20.31%

38.79%

307.30%

100.90%

119.96%

The Bangladesh stock market has been growing rapidly and currently constitutes about 30.95 percent of the country’s gross domestic product (GDP) as of December 31, 2009 against only 5.49 percent in 2005. On January 31, 2010, the total market capitalization of DSE was $ 31.65 billion, compared to less than $ 4 billion in 2005.

Market Liquidity (Turnover Ratio) Year

Total Value of Shares Traded ($ mn)

Market Capitalization ($ mn)

Turnover Ratio (%)

2005

1,018

3,588

28.38%

2006

934

4,526

20.63%

2007

4,686

10,772

43.50%

2008

9,749

15,235

63.99%

2009

21,302

27,479

77.52%

Investment Opportunities

The market capitalization (of DSE) to GDP ratio was 30 percent at the end of 2009 while it was 19.26 percent at the end of 2008. The current level of ratio ranks as one of the lowest in the world, with its neighbour India having 93.94 percent (NSE) Market Cap to GDP ratio. Listing of large cap companies over the next few years will help the capital market to grow further. In terms of risk and return among emerging markets, Bangladesh’s risk-return trade-off is very attractive. With 43.50 percent volatility, the DSE’s returns of 62.25 percent in 2009 clearly exceed the returns of other regional markets. Strong investor protection combined with favourable policy has made the stock market more lucrative to offshore investors in recent years.

2000

6,000

1500

4,000

1000

2,000

500 0

Turnover

25/Dec/09

25/Nov/09

26/Oct/09

26/Sep/09

27/Aug/09

28/Jul/09

28/Jun/09

29/May/09

29/Apr/09

30/Dec/08

DSE still has relatively low visibility among foreign investors, with just an average of 4-5 percent of turnover. Recent global economic fallout has not hurt the Bangladesh capital market as the volume of foreign portfolio investment in the country’s stock market is only around 3-4 percent of the total market capitalization and the exposure of local financial institutions in international markets is small.

8,000

30/Mar/09

Avg. Daily Turnover (% Change)

10,000

28/Feb/09

Avg. Daily Turnover ($ mn)

12,000

29/Jan/09

Mkt. Cap to GDP Ratio

14,000

(BDT million)

2005

DGEN

Facilities for Foreign Investors •

Non-resident persons/institutions, including non-resident Bangladeshi nationals, can buy/sell Bangladeshi shares and securities through opening NITA (Non-Resident Investors’ Taka Account) for easy funding of the purchase and easy repatriation of the sales and income proceeds. • 100 percent foreign ownership of companies with no exit restriction. • Opportunities of investment in Pre-IPO placement shares. • 100 percent repatriation of investment and profit. • No tax on capital gain. • Tax rebate to encourage companies to be listed on DSE and CSE. • Reinvestment of repatriable dividend is treated as new investment. Non-resident Bangladeshi investors enjoy facilities similar to foreign investors, including 10 percent reserved quota in primary shares/initial public offerings (IPOs).

Market Infrastructure and Scope for Development

Market infrastructure in frontier markets is not as sophisticated as developed markets. However, the existing market infrastructure in Bangladesh is fairly sound with automated trading systems, a competent regulatory body, short settlement cycles, ease of repatriation of funds, moderate tax rates, competitive transaction costs, and stringent regulations on corporate disclosures. No doubt, there is scope for improvement but investors will find existing market infrastructure as fairly sound.

BANGLADESH

A lot of investors are often concerned about regulatory compliance, insider trading, and front running of orders. However, even brokerage firms of stock exchanges have their own compliance committees, well-defined procedures, and measures to protect client confidentiality in trade execution as well as ensure that there is no front running of orders. There is room for development, which will give foreign investors more confidence to invest in our markets. This ranges from improving corporate disclosures, stricter regulatory compliance in curtailing insider trading, introducing short selling and derivative instruments as well as improving the depth of company and market research and availability of information for potential investors. This requires the co-operation of all market participants, including broking firms, the regulator and the stock exchange. However, the regulatory body has taken several

steps to help educate investors on the market through various publications as well as produce more in-depth research reports on listed companies to assist potential foreign investors. Stock exchanges are playing significant roles in promoting the efficiency of capital markets. This is primarily in promoting the market to local and foreign investors, educating the public, facilitating a supply of good quality issues in the market as well as taking the lead in initiating a diversification of trading products. A strong regulator that proactively takes initiatives to protect the interests of market participants is also essential for the development of frontier markets like Bangladesh. A strong regulator articulates rules and enforces them to contribute greatly toward improving transparency in the markets as also provide investors greater confidence in the capital market.

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Technology Infrastructure

Rating Industry Is Evolving

M Syeduzzaman

Chairman Credit Rating Agency of Bangladesh Ltd

M Syeduzzaman is a development administrator with a long experience in financial management and coordination of external assistance. He began his career in the Civil Service of Pakistan in 1956. He has held various positions including Secretary of the ministries of Finance and Planning and Principal Finance Secretary. Before he resigned from the government in late 1987, he was Minister for Finance of Bangladesh. Mr Syeduzzaman is a member of the Board of Trustees of the Centre for Policy Dialogue, the leading Civil Society ‘think tank’ of the country, since 1995. In 2003, Mr Syeduzzaman was elected Chairman of the newly established Credit Rating Agency of Bangladesh, a public limited company for providing credit rating services to financial and non-financial organizations. He is a sitting member of the International Advisory Council for the 2020 Vision Initiative of the Washington-based International Food Policy Research Institute (IFPRI) and also a sitting member of the Board of Trustees of the Industrial Rice Research Institute (IRRI) in the Philippines. He received his MSc in Physics from Dhaka University and obtained an MA in Development Economics from Williams College, Mass., USA.

CRAB was established for bringing in the highest standard of integrity and independent professional judgment of high quality and reliability into the emerging rating system in Bangladesh by including in the Rating Committee people with records of distinguished services in high positions in public and private institutions...

Credit rating agencies can help lenders pierce the fog of asymmetric information that surrounds lending relationships. At the same time, credit rating agencies can help borrowers (and their credit qualities) emerge from that same fog. It is because of this that the Securities and Exchange Commission (SEC) promulgated credit rating regulations in 1996, as part of financial sector reforms. Non-performing loans (NPLs) increased significantly due to the supply-led strategy of the government to finance the industrial sector in the late 1970s and early 1980s. Industrial enterprises were provided huge loans by the development financial institutions with little or no analysis of credit risks. Political interventions in the activities of the lenders were responsible for high default rates in the state-owned commercial banks (SCBs) and development financial institutions. In the case of private commercial banks (PCBs), insider lending and ‘benami’ lending by directors also raised the level of NPLs. Initiatives to reform the financial sector in Bangladesh can be traced back to the beginning of the 1980s when the denationalization of the Uttara Bank and Pubali Bank took place and licences were given to a number of new private commercial banks (PCBs). A new regulatory commission—the Money, Banking and Credit Commission—was constituted in mid-1980s to deal with the emerging problem of non-performance and also to define the scope and modalities of the early phase of reform. A number of initiatives, i.e., revision of banking regulations and enactment of laws and regulations and strengthening monitoring mechanism by the central bank (Bangladesh Bank), over the period contributed to the development of a reasonably healthy banking sector in Bangladesh. The ratio of gross NPLs to total loans of the banking sector decreased from 41.11 percent in end-1999 to 10.36 percent in the end of Q1FY10. During the period, gross NPL ratio for SCBs decreased to 23.6 percent, which contributed significantly in decreasing the overall ratio. The ratios for the PCBs and FCBs (foreign commercial banks) were 4.94 percent and 2.58 percent at the end of Q1FY10, significantly lower compared to SCBs and development financing banks. However, in the wake of global financial crisis, some impacts on exporting companies and financial institutions were observed, which may cause marginal increase in NPLs. These will be looked into at the time of rating and/or surveillance. The country’s capital market experienced gradual development and expansion. Dhaka Stock Exchange resumed its operation back in 1976 with only nine listed companies. Over the years, there had been significant development in the securities market, with 415 securities listed with DSE with a market capitalization of $ 27.28 billion (December 2009). The average growth of market capitalization had been 34.88 percent annually

BANGLADESH

between 1998 and 2008. The transaction volume also increased significantly with an average growth rate of 28.5 percent during the same period. However, the average P/E ratio has been quite high compared to those of many other markets. The average P/E ratio was 23.58 at the end of 2007. In Bangladesh, the supply of new securities in the market had been limited. During the period of 1998-2008, an average of 10 IPOs entered the market and raised capital of BDT 2.77 billion every year. However, the depth of capital market is still very low compared to banking assets. Against this backdrop, the SEC promulgated the Credit Rating Companies Rules 1996 to facilitate credit rating services to the financial sector. Under the Rules and subsequent rules and regulations, i.e., Securities and Exchange (Rights Issue) Rules 2006, SEC Rules 2004 (Asset-backed Security Issue), ratings became mandatory for public offering of all debt instruments such as bonds, debentures, commercial papers, asset-backed securities, preference shares, public issue of shares at premium, and all rights issues at premium. The SEC gave its first licence to Credit Rating Information Services Limited (CRISL) in 2002, a joint venture of Malaysia Berhad (RAM), JCR-VIS Credit Rating Company of Pakistan, and a few financial institutions and professionals of Bangladesh. Credit Rating Agency of Bangladesh Limited (CRAB) was established in 2003 and received licence from the SEC in 2004. The sponsors are some leading personalities and professionals from a few private and public institutions. CRAB has technical collaboration with ICRA Limited, India, a subsidiary of Moody’s Investors Service, USA. Both CRAB and CRISL are non-listed public limited companies and active members of the Association of Credit Rating Agencies in Asia (ACRAA), established with support of the Asian Development Bank (ADB). Credit Rating in Bangladesh is regulatory driven. Penetration of both the rating agencies was very limited in the initial phase; there were few public offering debt instruments and public issuance of shares at a premium during the initial period of 2004-06. However, some non-banking financial institutions/ non-financial companies also opted for rating to enter the capital market and to raise loans from financial institutions. In 2007, both Bangladesh Bank and Insurance Authority (Chief Controller of Insurance) made rating compulsory for banks and insurance companies on a regular basis. There are 48 commercial banks and 42 general insurance companies that are to be rated annually and 18 life insurance companies to be rated bi-annually. Therefore, except rating of banks and insurance companies, most of the ratings were for one time. Due to the absence of surveillance contracts, the rating agencies were unable to construct the transition matrix. However, recent amendment (November 2009) in the CRC Rules 1996 stipulated that if an agreement for entity rating is executed with a CRC, the CRC shall perform surveillance rating at least for the next three years after the initial rating, and for an issue or instrument rating, CRC shall perform continuous surveillance rating for the lifetime of the instrument. The new rules would assist the rating agencies to monitor and validate their rating and methodology. In recent times, Bangladesh Bank has asked banks to move in the direction of implementing the Basel II norms and identify

the areas that need strengthening. In implementing Basel II, Bangladesh Bank is in favour of gradual convergence with the new standards and best practices. The aim is to reach the global best standards in a phased manner, taking a consultative approach rather than a directive one. In anticipation of Basel II, Bangladesh Bank has requested banks to form a committee comprising top management personnel to chalk out a plan and procedures for implementing Basel II guidelines within the bank. Bangladesh Bank has set up a steering committee to suggest migration methodology to Basel II. To comply with international best practices and to make banks’ capital more risk-sensitive as well as to build the banking industry more shock-absorbent and stable, Bangladesh Bank issued guidelines on ‘Risk Based Capital Adequacy for Banks’ on December 31, 2008, for a parallel run of Basel II with Basel I in 2009, and full compliance with Basel II guidelines from 2010. The guidelines stipulated the following approaches in order to calculate capital adequacy of banks (Minimum Risk Weighted Capital Adequacy Ratio >= 10.0 percent or paid-up capital plus statutory reserve BDT 2,000 million by June 2009 and BDT 4,000 million by June 2011, whichever is higher). The guidelines stipulated Standardized Approach for calculating Risk Weighted Assets (RWA) against Credit Risk, Standardized (Rule-Based) Approach for calculating RWA against Market Risk, and Basic Indicator Approach for calculating RWA against Operational Risk (new element added). The standardized approach to credit risk, which was adopted by Bangladesh Bank, would gear banks’ capital requirements to the credit ratings of the borrowers of banks and this will clearly increase the demand for ratings in Bangladesh. The BIS recognizes that the reliability of the credit rating firms—the BIS uses the phrase “external credit assessment institutions” (ECAIs)—is crucial for the “standardized approach” to be effective and that bank regulators must certify the ECAIs. In April 2009 , Bangladesh Bank accredited both CRAB and CRISL as ECAI after fulfilling the following six specifies criteria that both ECAIs satisfied: 1) Objectivity: rigorous methodology and historical validity of its credit assessments; 2) Independence: not subject to economic or political pressures; 3) International access/transparency: assessments available to both domestic and foreign institutions—the general methodology should be publicly available; 4) Disclosure: both qualitative (e.g., definition of default, time horizon) and quantitative (actual default rates in each assessment category, transition rates from one assessment category to another over time); 5) Resources: sufficient resources to carry out high quality credit assessments, including ongoing contacts with the managements of the assessed entities— assessments to be based on methodologies combining qualitative and quantitative approaches; and 6) Credibility: independent parties’ use of assessments—existence of internal procedures to prevent the misuse of confidential information. Under Standardized Approach, ratings assigned by credit rating agencies are to be used to calculate risk-weighted assets. Internal Rating Based Approach may be followed after the banks attain sufficient experience in implementing the standardized approach and necessary data and systems are in place and regulators feel comfort of such data and systems.


Going by the mapping, counterparty/ exposure (under corporate) of banks rated AAA would attract 20 percent Risk Weight (RW), AA1&AA2 would attract 50 percent RW, AA3 to BBB3 would attract 100 percent RW, BB1 to D would attract 150 percent RW while unrated would attract 125 percent RW. For retail exposures, which banks in Bangladesh are increasing by focusing on for asset growth, 75 percent RW may be assigned in line with the Basel II norms, except for 90 days past due loans and consumer loans. For claims fully secured by mortgages on residential property and occupied by the borrower, Bangladesh Bank specifies a risk weight of 50 percent, which is significantly lower than the existing risk weight. Claims secured by commercial real estate, 100 percent risks to be assigned. Unsecured portion of any loan that is past due more than 90 days, weight may vary within the range of 50 percent to 150 percent, depending on the level of provision. In order to ensure capital adequacy, a bank will have the option to raise and maintain its capital in three forms, i.e., Tier-I, Tier-II and Tier-III. Banks counting of capitals under Basel II are beyond the simple accounting definition of equity and reserves. Tier-I “core” capital corresponds to the strict definition of capital, being shareholders investment (paidup capital), reserves for loan losses, and retained earnings. This is the highest tier and can be used to support trading and banking activities without restrictions. Tier-II “supplementary” capital includes the “slower” sources of funding such as certain provisions, perpetual senior debt, subordinated debt whose maturity is greater than five years, and certain preferred shares. Tier-III capital comprises short-term subordinated debt, with minimum original maturity of two years. The use of Tier-III capital is restricted to trading activities only and is not eligible to support credit risks. The aggregate of Tier-II and Tier-III capital may not exceed 100 percent of Tier-I capital allocated. Compliance with these guidelines will call for rating requirements and will open up business opportunities for the ECAIs. Recently, a few banks came forward to issue convertible subordinated bond for Tier-II capital and several issues are in the pipeline. CRAB already rated two Subordinated Convertible Bonds that were rated AA3 and A2. Based on asset quality, market risk and operational risk, as revealed by rating, some banks may require to increase their capital immediately, some banks may need to enhance capital in the medium term, though some banks may be well positioned in terms of capital adequacy. In the light of this situation, Bangladesh Bank on March 10, 2010, relaxed guidelines on risk-based capital adequacy for banks, considering the overall financial position in the country’s banking sector. Under the amended guidelines, banks will have to comply with the minimum capital requirement (MCR) at 8.0 percent from June 30, 2010, instead of January 1, 2010, while a rate of 9.0 percent will have to be maintained from June 30, 2011, instead of July 2010. The banks, however, must comply with the MCR of 10 percent from July 2011 onwards. Going forward, the loan portfolio of banking industry is growing at a consistent rate and is likely to maintain in the medium term to long term. Therefore, banks will be under continuous pressure to meet the capital requirement. In order to meet the risk-weighted regulatory capital requirements, there are broadly four courses of action by the banks, i.e., (i) take initiative to conduct the counterparty rating, but it will depend on willingness of the counterparty as well as induction of rating based pricing mechanism by the banks ; (ii) issue bonus share (depends on earnings of a particular bank) and rights share; (iii) issue subordinated and hybrid (yet to be finalized by Bangladesh Bank) bonds (for inclusion as

Tier-II & Tier-III capital); and (iv) continuous portfolio management (asset concentration management). CRAB was established for bringing in the highest standard of integrity and independent professional judgment of high quality and reliability into the emerging rating system in Bangladesh by including in the Rating Committee people with records of distinguished services in high positions in public and private institutions. CRAB has maintained a clear division of responsibility between the Promoter-Directors, Rating Committee members and the professional staff members. During ECAI recognition process by Bangladesh Bank, some uniformity in methodology and practices between two rating companies took place. However, there are distinction in Notches and Symbol; i.e., CRAB uses 22 Notches (AAA, AA1, AA2…D) while CRISL uses 26 Notches (AAA, AA+, AA-…D). In the Rating Committee composition, CRAB has set up an External Independent Rating Committee while CRISL has an Internal Rating Committee. Both the rating agencies follow “Issuer Pays Model”. Companies are reluctant to pay fees that are reasonable and negotiations go on. Both CRAB and CRISL have “list prices” for the requested ratings and both offer negotiated rates for frequent issuers and group companies. The strength of CRAB includes: 1) adequate staffing, financial resources, and organizational structure to ensure that it can issue credible and reliable ratings , including the ability to operate independently of economic pressures or influence by companies it rates, and adequate number of professional staff members qualified in terms of education and expertise to thoroughly and competently evaluate an issuer’s credit; 2) use of systematic rating procedures that are designed to ensure credible and accurate ratings; 3) extent of contacts with the management of issuers, including access to senior level management of the issuers; 4) internal procedures to prevent misuse of non-public information and compliance with these procedures; 5) training facilities at home and abroad; and 6) seminars with potential clients. Regulatory directives are gradually increasing the volume of rating activities. Borrowers’ credit ratings in assessments of the adequacy of banks’ capital have heightened general interest in the credit rating industry. But coverage is still small. In the coming months and years, the volume of work for rating companies will increase. Absence of benchmark bonds and yield curve, market distortion caused by the national savings schemes, high transaction costs of bond issuance, default of debentures in the past, general preference of investors in the equities rather than in bonds, unwillingness of many companies to meet the disclosure requirements, absence of market infrastructure are behind the underdeveloped bond market in Bangladesh. Accordingly, credit rating in bond market has not been active. However, there is a need to develop the debt market to cater to the increasing demand for funds, inter alia from banks, infrastructure projects and long-term industrial projects. The government has been working on developing the debt markets, including issuing benchmark treasury bonds with maturities of 5, 10, 15 and 25 years. Besides, the Government of Bangladesh may explore the capital markets as an avenue for financing large infrastructure projects based on public-private participation. It will also offload public sector entities. Therefore, the outlook for expanding local debt market and credit rating activities is also promising. No wonder, efforts are underway by some entrepreneurs and professionals to set up new credit rating companies. The regulatory authorities seem to be aware of this development. So, the rating industry in Bangladesh will continue to evolve and expand in the coming years.

BHUTAN


Exchange Industry

Response

Exchanges Stock

Number

1

Commodity

Number

0

Capital Markets

Mutual Fund Industry Regulator

Name

Royal Monetary Authority

Fund Houses

Number

None

Other Asset Classes Currency Markets (Exchange-traded)

N/A

Regulator

Name


Commodity Markets

Brokers

Number

4

Banking

Registrars

Number

1

Regulator

Name


Name

N/A

Custodians

Number

1


Number

4

FIIs

Number

0

Public Sector

Number

4

Merchant Bankers

Number

0


%

47.75


Number

0

NPA

$ mn

25.64

Depositories

Number

1

NPA/Net Advances

%

6.21

Companies Listed

Number

21

Net NPA/Total Assets

%

0.10


$ mn

171.66



%

8.95

Bank Assets to GDP


%

93.58

Turnover (2009)

$ mn

13.79


%

35.60


%

14.90

Products Offered Settlement Cycle

Equities, G-Secs & Corporate Bonds T + ….

T+3

15.45 %

91.35

BHUTAN

Growth of Financial Markets

Dorji Phuntsho

Chief Executive Officer Royal Securities Exchange of Bhutan Ltd

Dorji Phuntsho began his career as Assistant Examining Officer in the Financial Institutions Supervision division of Royal Monetary Authority of Bhutan. Later, he became Head of the Securities Surveillance Unit. Recently, he joined Royal Securities Exchange of Bhutan Limited as Chief Executive Officer. Mr Phuntsho holds masters degrees in Economics and Business Administration (Corporate Strategy and Economic Policy).

Royal Securities of Exchange of Bhutan Ltd (RSEBL) was established in 1993 by the initiative of the government to provide a platform for raising capital, mobilize savings, diversify share ownership in enterprises, and provide liquidity to the investors...

Overview

Bhutan ventured into modern economic development with the start of five-year plans in the late 1950s. Till then the country was basically an agrarian society on a subsistence basis and, in absence of a monetized economy, surpluses were traded under the barter system, though use of gold and silver coins was prevalent among the privileged class of society but limited to trade with the neighbouring countries. However, with the inception of modern economic development and the government being the driving force behind the advancement of strategic sectors, the need for appropriate monetization of the economy was felt crucial and necessary. As a result, in 1968, the first commercial bank was established, which also took up the role of the central bank. Since then major developmental activities carried out were primarily funded through aids and grants from the donor countries and external agencies. Given the limited size of the economy and a nascent private sector, the need for investment and funds from the financial markets were restricted. However, towards the end of 1980s, in the surge to attain self reliance and promote capital formation in the economy, the government gradually shed its policy of centralized economy and encouraged public participation in the mainstream economic development. This step had called for a need to develop a capital market that would act as an impetus for capital formation and private sector development. Royal Securities of Exchange of Bhutan Ltd (RSEBL) was established in 1993 by the initiative of the government to provide a platform for raising capital, mobilize savings, diversify share ownership in enterprises, and provide liquidity to the investors. At present, the Bhutanese financial system comprises Royal Monetary Authority at the top, whose function is consolidated with that of a central bank, Securities Exchange Commission, insurance and pension regulator, followed by two commercial banks, a development bank, an insurance company, and a pension fund. During the end of 2009, with the intention to create positive competition in the financial sector and cater to the needs of the public, the central bank has given in-principle approval to two new commercial banks and an insurance company. The emergence of these companies is likely to make some improvements in the money market. On the capital market front, a platform for capital formation has been introduced with the establishment of RSEBL, but given the size of the economy and resource constraints the market is yet to be developed. However, in the years to come, if the government decides to divest the ownership of state-owned conglomerates to the public and with entrance of foreign companies, a vibrant capital market will emerge.



Background

Royal Securities Exchange of Bhutan Ltd. (RSEBL) was established in 1993 by the government to provide a platform for raising capital, mobilizing savings, diversifying share ownership in enterprises, and providing liquidity to the investors. It was developed under the technical assistance of the Asian Development Bank as a non-profit making organization. During its inception, only four companies were allowed to be listed on the Exchange. The total market capitalization of these four listed companies was initially around Nu 193 million with a total of 2,000 shareholders. Since no private individuals were interested to venture into brokerage business, RSEBL requested the financial institutions to establish brokerage firms so as to intermediate in the market. These four brokerage firms are wholly owned subsidiaries of the four financial institutions and as of date no other firms or individuals have approached or indicated their interest to take up brokerage business. This is due to the fact that the market has remained dormant. The concept of the capital market is still new to many of the domestic investors and given the size of the economy with limited financial products, the market is yet to grow into a full-fledged capital market. Other factors such as inaccessible terrains and lack of infrastructure have also contributed to the slow growth of the capital market. The financial literacy rate among the general public is also low and the concept of investing in the capital market is still an unknown phenomenon. Despite the fact, the investment in the securities market has witnessed a steady growth during the last few years. The introduction of short-term discount bills of the central bank and Treasury bills and bonds of the government have also brought about a positive change in the market. In the future, if the government decides to divest the shares of the stateowned companies to the public at a reasonable price, as an incentive to the domestic investors, a major turnaround in the capital market will take place. Today, RSEBL has 21 listed companies with a total market capitalization of over Nu 7.3 billion (approx. $152.8 million) during the end of 2008. The total number of shareholders has now grown to over 16,000, which is roughly 2.28 percent of the total population, and the market capitalization amounts to 12 percent of GDP.

Features of the Exchange

Although RSEBL is isolated from rest of the world, the Exchange has in place a customized model of market facilities, which are developed based on a varied menu of accepted best practices. RSEBL is incorporated under the Companies Act, 2000, of the Kingdom and licensed under the Financial Institutions Act, 1992.

The activities of the Exchange are supervised and regulated by the Royal Monetary Authority of Bhutan (RMA), as the Securities Exchange Commission. The role to regulate the capital market by the RMA, in the absence of a strong legal framework, has been a challenge since the inception of RSEBL. Nevertheless, every effort is now being made to establish a strong legal framework for ensuring fair, efficient, and transparent market and provide adequate protection of investors. So far, the effectiveness and the efficiency of the market were left solely on the hands of the Exchange with little guidance from the RMA besides approving the rules and regulations of the Exchange and licensing of the securities dealers. With the replacement of the current Financial Institutions Act, 1992, by the New Financial Services Act, a major change in the functioning of securities business is anticipated. Beside the central bank being the Securities Commission, the Exchange also regulates the activities of the member firms and ensures that the listed companies comply with its existing rules and regulations.

Membership

The shares of the Exchange since its commencement are sold to four brokerage firms that are approved as members. This is done with the intention that they will have financial commitment to the Exchange and interest in ensuring that the Exchange operates efficiently. The Exchange is a quasi public institution with non-profit making motive and the proceeds from its operation is to be utilized for future development until such time the Exchange is able to generate substantial profit. The brokerage firm should apply for membership of the Exchange and only after demonstrating satisfactory capital, management and staffing, the Exchange approves its membership. In the coming years, with the entrance of new brokerage firms, a bifurcation of the trading participants as member participants and participants is expected.

Trading System

The method of trading is on an agency basis. All orders to effect a change in ownership in securities issued to the public are channeled through the facilities of the Exchange. The trading process is order-driven and the public can represent their orders through their brokerage firms in the market and establish the best bid or offer. The orders are individually maintained in the electronic book operated by RSEBL and are visible to the market to encourage competition in the price discovery process. The trading of securities is done through automated trading system, linked through Local Area Network at the trading floor. Equity trading in the secondary market takes place at the trading floor of the Exchange on every Tuesday and Friday at 11.00 a.m. However, bills and bonds do not trade on a regular basis, and so far no secondary trading has occurred in the debt market. The market determines the price of securities based on supply and demand in the market.

BHUTAN

Primary Issues

In Bhutan, the primary market is regulated under the Companies Act where the prospectus of the issuing companies must be approved by the Registrar of Companies. However, there are some different opinions regarding the approving authority between FIA and the Companies Act, 2000, related to the prospectus of the financial institutions.

The Secondary Market

The secondary market has picked up despite the fact that only less than 30 percent of the total outstanding shares remain in the hands of public investors. The remaining 70 percent are either owned by state or the promoters of the companies, who seldom enter the secondary market.

Clearing and Settlement

In order to maximize the efficiency of settlement of trades and minimize the risk of financial loss from delays or failure to settle trades, both money and securities are deposited in advance, within T+0 as short selling is not allowed for the time being, except for collaterals undertaken for payments within T+3 days by the lending banks. All settlements for equities are settled within three business days after trade date (T+3) and all debt securities are cleared within T+1.

Central Depository

The Central Depository (CD) has been kept as a division of RSEBL and it maintains share registers of listed companies in its book entry records after every trading. Ninety-nine percent of the securities outstanding in the market have been deposited in the Central Depository especially after having opened in demat account in the year 2007. Dematerialization of the physical share certificates has helped the Exchange to streamline the shareholders register along with increase in the efficiency and accuracy in maintaining the register. The process has also

enhanced the effectiveness of surveillance and auditing of brokerage firms. Further, the conversion has reduced the cost burden and workload of the listed companies. Since the Depository is supposed to be operated under the direction and authority of the central bank as per the previous arrangement, lack of proper legal framework has been identified as a bottleneck at present. However, with the enactment of the new Financial Services Act, provisions are laid out for the issue of new depository rules and regulations. Further, Clearing House and the Central Depository shall be separated from the Exchange as separate entities once their businesses become profitable.

Listing Regime

Along with other rules and regulations of the Exchange the listing rules also have been drafted under the technical assistance of the ADB. The listing rules are simple and comprehensive to suit the needs of our market condition. Further efforts can be made to standardize the listing rules, which are in line with the regional listing regimes of SAFE.

Foreign Investors

As per the Companies Act, 2000, of the Kingdom, the Bhutanese capital market remains open for Bhutanese nationals only. However, the Ministry of Economic Affairs has already drafted FDI legal framework that would open the door to foreign investors.

Future Plan

Once the new Financial Services Act is enacted, there will be a major change in the structure and operation of the Bhutanese capital market. Although the scope is limited to the level of economic development, as a way forward for future growth of the capital market, there is hope for a comprehensive legal framework and infrastructure that meet the international standards.


INDIA

Bombay Stock Exchange Ltd MCX Ltd MCX Stock Exchange Ltd National Multi-Commodity Exchange of India Ltd National Securities Clearing Corporation Ltd National Stock Exchange of India Ltd

Exchange Industry

Banking

Exchanges

Regulator

Name

Reserve Bank of India

Number

22


Number

80

National

Number

3

Licensed Specialized Banks

Number

14

Commodity

Number

26

ATMs

Number

43651

National

Number

4


%

72.4

NPA/Net Advances

%

1.1

Stock

Capital Markets


%

14.1


%

6

Prime Lending Rate

%

11-12

Bank Assets to GDP

%

98.5

Regulator

Name

Securities and Exchange Board of India

Brokers

Number

9719

Registrars

Number

55

Custodians

Number

16


FIIs

Number

1691

Regulator

Name

Securities and Exchange Board of India

Merchant Bankers

Number

156

Fund Houses

Number

46

Depositories

Number

2

Total AUM

Indian Rs cr

758,712

Companies Listed

Number

4973


Rs bn

5,925,725

Commodity Markets


%

-40

Regulator

Name

Forward Markets Commission

Exchanges

Number

26

PE Ratio (Dec 31, 2009)

13.65

Broker Members

Number

2185

Products Offered

Equities, Corporate Bonds, G-Secs, T-Bills, Commercial Paper, ETFs, Mutual Funds, Warrants, Debentures & Derivatives

Terminals

Number

7808

Major Commodities Traded

Name

Gold,Silver, Crude Oil, SoyaBean, Soya oil, Chana, Turmeric

Settlement Cycle

T + ….

T+2

Currency Markets (Exchange-traded) Regulator

Name

SEBI & RBI

Exchanges

Number

4

Broker Members

Number

1431

INDIA

Primary Markets Beckon Investors

M V Ramnarayan Director Link Intime India Pvt Ltd

M V Ramnarayan co-founded Spectrum Corporate Services Limited in 1983, which eventually evolved into Link Intime India Pvt. Ltd. Link Intime (erstwhile Intime Spectrum) is today a leading registrar serving over 900 listed companies all over India and has handled the highest number of IPOs as Registrar during 2005-09. Mr Ramnarayan has played a pivotal role in the development of Link Intime. He has vast knowledge on all the back-office functions in the capital market and other commercial transaction processing areas. He was the Chairman of the Registrars’ Association of India (RAIN) during 2004-07. He was also a member of the Executive Committee of the National Securities Depository Ltd. (NSDL) during 2001-05. Mr Ramnarayan is a qualified Chartered Accountant.

Apart from the general distrust of share markets, the average Indian is generally ignorant of the vast wealth-growing opportunity that equity markets provide. These factors and the periodic slumps in the market, including the last slump in 2008 due to the global meltdown, have led to the current situation where the retail investor is ‘wary’ and ‘choosy’ about the IPO he/she invests in...

Growth and Evolution

India’s first stock exchange, Bombay Stock Exchange Limited (BSE), is nearly 150 years old, but it is only in the last 35-40 years that the primary market has evolved and developed as one of the main avenues for capital raising. The Initial Public Offering (IPO) of Reliance Industries in 1977 was a watershed event, which left an indelible mark in the minds of the investing public. In the decade that followed, IPOs were largely from established business houses or multinational companies, with the objective of raising additional capital or to dilute the promoter holdings in order to conform to the then prevailing norms. The immediate post-liberalization era saw the sprouting of several first-generation entrepreneur-driven IPOs, including that of the now iconic Infosys. But, by and large, both the quality of IPOs and the amount raised during this period were significantly lower compared to other markets. The advent of the Securities and Exchange Board of India (SEBI) as the market regulator in 1992 was a significant driver for the entire capital market and marked the beginning of the revolution that was to take place in the years to come. Till 1992, IPO pricing was determined by the Controller of Capital Issues through a process that was not only time-consuming but also unrelated to the market requirements and compulsions. Around 4,738 IPOs hit the market during 1992-97, and a majority of them were of poor quality. A lot of these listed companies and their promoters soon ‘vanished’, resulting in huge losses to the investing public. SEBI tightened the disclosure norms, including curbing misleading advertisements, and also put more onuses on the merchant bankers, and these measures had their effect. The number of offerings came down thereafter, and there was a lull in the primary market during 1998-2003. IPOs that hit the market post-dotcom bust and the resultant slump, after 2003, had much better quality paper on offer, and the amount raised through the primary markets also sharply increased. While the average amount per IPO was around Rs 118 million during 1992-97, it was around Rs 4,160 million during 2003-09 (on a much lower 368 IPOs). The capital market milestones that significantly contributed to the IPO scenario today are:

Today’s Scenario

Retail participation in primary markets in India has been a subject of debate. While one view has been that the retail investor should not be part of the book building and price discovery process, the other view is that, whether institution or retail, the risk exposure is the same in percentage terms. Consensus has veered around to the view that in India the retail investors are a significant constituent and lend balance to the financial markets.



It is also perceived that going public without retail participation is a misnomer. Yet, compared to the country’s rate of savings and population size, the number of retail investors in the entire equity market is very insignificant—3 percent of the total population as compared to around 30 percent in the US. Apart from the general distrust of share markets, the average Indian is generally ignorant of the vast wealth-growing opportunity that equity markets provide. These factors and the periodic slumps in the market, including the last slump in 2008 due to the global meltdown, have led to the current situation where the retail investor is ‘wary’ and ‘choosy’ about the IPO he/she invests in. Year

Event

1992

IPO pricing taken out of Controller of Capital Issues; free pricing regime begins

1996

National Securities Depository Ltd (NSDL) begins the electronic trading era

2002

SEBI mandates Book Building as the route for IPOs over Rs 100 million

2006

SEBI exposes IPO-related scam of a systematic attempt at cornering IPO allotments, which leads to further process / system clean-ups

2008

SEBI introduces ASBA— Applications Supported by Blocked Amounts—as an alternative application mode, thus making refunds redundant

IPO Pricing

Pricing is the crucial factor that determines the success or failure of the IPO. There is no magic formula for arriving at the golden mean, which satisfies both the promoter and the investor. Often the investment banker is at his/her wits’ end, trying to achieve the balance, and there are as many issues which fail or just scrape through as there are winners. It is only hindsight that offers wisdom, and it is a wise merchant banker who does not crow about his success. So many extraneous factors impact on the success of an IPO and even a hugely successful one like that of Reliance Power in January 2008 (which attracted around 5 million applications), had to beat a hasty retreat and announce an unheard of bonus to the allottees in order to compensate the investors for a deep fall in the post-listing price. The weight of opinion is in favour of that price which should at least leave around 8-10 percent for the investor on the date of listing, with a potential to steadily rise thereafter based on fundamental business issues of the company, for the benefit of long-term investors. But this is easier said than done. The lukewarm response to the recent PSU offers of NTPC and NMDC reveals that the investor of whatever category has become ‘street-smart’. The media has played a large role in this transformation and the availability of extensive analysis has helped the investor to take the right decision.

Recent Developments and Pointers to the Future

Some of the important recent developments and policy guidelines that will influence the future course of primary markets are:

1.

2.

3.

4.

The increasing use of ASBA as an alternative means of payment of application money. Currently, only about 15-20 percent of the applications are ASBA-based, but with increasing awareness and extension of the facility to all categories of applicants, the quantum is bound to increase. Effective May 2010, QIBs, who hitherto had to pay only 10 percent, will have to pay 100 percent of the bid amount. This measure is aimed at preventing unrealistic high initial bids. This also has to be seen in combination with the other recent directive that the subscription summary data, which is put on the public domain by the stock exchanges, will be restricted to end-of-day upload and not on an hour-to-hour basis. It is proposed that all allotments, whether to private equity players, promoters or ESOPs to employees, prior to the IPO will be deemed to be all part of the promoters’ holding and subject to the same rules of ‘locked-in’ shares. Thus, these allottees will have to hold the shares for a minimum period of 12 months (which can go up to 36 months), before offloading their holding in the market after the shares are listed. This is aimed at bringing in greater commitment from all stakeholders prior to the IPO. Another paradigm shift in the offing is the drastic reduction in the timeline between the closing of the IPO and its listing—initially this period will be reduced from the existing 21 days to around 12 and subsequently to seven days. This can be only achieved by eliminating multiple data entry points of an IPO application and rationalizing the listing formalities and compliance rules of the exchanges and the depositories. Notification of the guidelines to achieve the first target of 12 days is already announced by SEBI and it will be implemented for all IPOs effective May 2010. This change should reduce the risk exposure window of the investor from the time of the application to the listing date and bring about greater process efficiency.

The Outlook for the Future

The Indian economy is poised for an 8 percent YoY growth in the next 5 years. Infrastructure, communication and new technology-based businesses are the sectors expected to attract massive investment inflows. Government disinvestment plans are fully underway. All these factors will contribute to a vibrant IPO market in the next 2-3 years. Demographic changes in India also point to increased participation in equity markets by the growing segment of ‘young Indian middle class’. Regulatory changes, while pushing the process into a paperless one, will also contribute to a cleaner, efficient, and more transparent system. While the bulk of the subscription in terms of the amount raised will continue to come in from QIBs / HNIs, the quality of the offer and the ‘right’ price will ensure active retail participation. Overall, the primary market is entering a ‘healthy’ phase and beckons the investor to participate in the India growth story.

INDIA

Mutual Fund Industry May Witness Consolidation

Santosh Das Kamath Chief Investment Officer, Fixed Income Franklin Templeton Investments, India

Santosh Kamath oversees the fixed income investment functions of the locally managed and distributed debt products. He joined Franklin Templeton Investments in 2006. Prior to joining Franklin Templeton Investments, Mr Kamath was the CIO at ING Investment Management (India) Pvt. Ltd. He was fund manager at Zurich Asset Management Company (India) Pvt. Ltd. (2000-2003), responsible for overseeing Fixed Income Fund Management. Mr Kamath was the head of Capital Market Research at CRISIL Ltd., responsible for developing specific tools for financial markets and financial research (1997-2000). From 1995 to 1997, he was the fund manager at Jardine Fleming India Asset Management Ltd., responsible for research and managing India-specific funds and offshore funds. Mr Kamath was the fund manager at SBI Funds Management Pvt. Ltd. from 1993 to 1995, and responsible for managing Asian Convertible Income Fund (ACIF). Mr Kamath is an Electronics and Telecom Engineer from REC, Bhopal. He also holds and MBA from XLRI, Jamshedpur.

Despite the strong growth witnessed in recent years, the share of mutual fund assets as a percentage of total GDP remains low compared to developed markets—about 15 percent in India compared to around 70 percent in the US...

The global mutual fund industry has emerged from the financial crisis in a good shape helped by the buoyant market conditions, inflows into bond funds and easy liquidity conditions. However, asset managers are grappling with challenges posed by increased regulatory oversight, low retail investor confidence and growing popularity of ETFs. The change in asset mix is impacting operating profitability and we have witnessed heightened consolidation with many institutions in the developed markets divesting their asset management arms. Like its global counterparts, the Indian mutual fund industry today stands at an inflection point in its journey. The robust economic growth, buoyant equity markets and increased comfort with marketlinked products, especially in the urban areas, had helped the industry grow at a strong pace (2003-07). However, market volatility and new regulations have led to dramatic changes in the business environment over the last couple of years. The industry needs to use these conditions to lay the foundation for sustainable growth by focusing on investor education and increasing retail penetration. By building the right platforms for sustainable growth, the industry can profit from the available opportunities.

The Journey So Far

The Indian MF industry has undergone dramatic transformation since the sector was opened up for private players in 1993. Transparency and service levels have improved, as also product innovation and fund performance. A sustained bull run in the equity markets that started in 2003 and increased demand for FMPs resulted in industry assets touching an all-time high in April 2008. During this period, the increasing comfort of Indian investors with the equity asset class had resulted in equity products share in the industry assets moving to a high of 43 percent in 2006. The market rebound over the last year has resulted in increased assets under management, but growth has been driven mainly by increased inflows into income and liquid/ liquid plus funds, with equity funds witnessing inflows in 2010. As of March 31, 2010, the industry had Rs 766,869 crore in assets across 38 players, implying a compounded annual industry growth rate of 38 percent (as of March 10) over the last five years, despite the contraction in 2008-09. The institutional flows have been a key ingredient of growth for most industry players and the share of short-term assets (read liquid/liquid fund assets) have increased to 57 percent of industry assets.



Some of the key trends witnessed over the last decade on various fronts have been the following: Products: At the start of the decade, the industry product range was dominated by plain vanilla products (like equity, income and liquid funds). This has changed with players launching products such as dynamic asset allocation funds, overseas funds and ETFs amongst others. The product range for most of the leading players is quite comprehensive, catering to most investor needs. Distribution: The distribution landscape has undergone a sea change— the entry of banks in the distribution has helped industry expand reach. The recent regulatory change allowing stock brokers to provide MF trading facilities opens up another avenue for investors to access MF investments. Technology: The use of technology to reach out to investors and enhance their investment experience has led to the introduction of various mobile and web-based services, along with an increased focus on online transaction capabilities and investor-friendly web tools. There have been efforts to build open architecture platforms and an industrywide distributor platform.

Growth Drivers

Despite the strong growth witnessed in recent years, the share of mutual fund assets as a percentage of total GDP remains low compared to developed markets—about 15 percent in India compared to around 70 percent in the US. Penetration at 7.7 percent of household savings is also quite low. This provides tremendous growth potential in a fast-growing economy like India. Some of the key growth drivers for the coming years would be: Demographics/Savings: Over 50 percent of the population is estimated to be less than 25 years of age and the percentage of working population is expected to grow substantially in the coming years. Increased income levels, higher savings rates and younger population will boost demand for professional managers. Pension reforms: Retirement assets constitute a key component of global mutual fund assets in the US; over 33 percent of the industry assets are retirement-related. While there has been some progress, the very low fees cast a shadow over the sustainability. Managing insurance assets: Globally, many insurance companies outsource asset management to specialist asset management firms. This gives them the opportunity to focus on their core competencies. Enabling regulation is required for this to happen in India. Overseas investment opportunities: With Indian investors opening up to the idea of participating in high-growth markets elsewhere in the world, we expect this segment to grow substantially over time.

Global investors: Given the rise of India as an asset class in recent years, the industry has the opportunity to tap NRIs as well as global investors for mandates and India-dedicated funds domiciled overseas. However, to fully realize the growth potential in India and build a stable investor base, the industry needs to tackle key issues such as investor awareness along with education. We believe that as an industry our objective is to ensure that investors buy mutual funds in line with their risk appetite and long-term financial goals. This also means that advisors have to be well trained and fully equipped to guide investors in the right manner.

Regulatory Changes

Globally, regulators are looking to enhance investor focus and the regulatory changes in India seem to be in line with the same. However, the slew of measures has resulted in uncertainty amongst financial advisors regarding their business models and has impacted inflows. We expect this to continue until distributors/ financial advisors are able to align their business models to the new scenario. Overall, the thrust of the regulations seems to be focused on protecting investor interests, enhancing disclosures/communication and improving the retail penetration. While the household savings rate is high in India, most of these savings find their way into unproductive physical assets such as gold and real estate. While there has been a gradual increase in the share of financial assets, this could be further encouraged by providing tax benefits to channel the high savings into capital markets, financial institutions such as banks, mutual funds and insurance, and also to fund infrastructure development. Overall, financial regulations in India need to have a uniform standard across players and need to provide tax benefits for retirement, children’s savings and healthcare (as is prevalent in the West). This would encourage financial planning and savings for critical needs of all investors.

Summary

Given the change in regulations, the industry is likely to witness consolidation as players with unsustainable business models exit and the thrust of the business will change. Over the near term, the industry will be impacted by the recent regulatory changes as distributors and fund houses put in place new payout structures and review their business models. The future growth of Indian mutual fund industry will depend upon its ability to garner a higher share of household savings. The long-term prospects for industry growth remain intact, particularly as it benefits from the demographic shifts and rising incomes. We believe that with a favourable policy framework, the industry could grow between 15-20 percent over the next 3-5 years.

INDIA

South Asia Needs More Commodity Exchanges

Ashok K Mittal

Vice President and Country Head Karvy Comtrade Ltd

Ashok K Mittal has more than 17 years of experience in various fields in financial markets, including banking and finance, foreign exchange trading, treasury management, equities and commodities derivatives. He has vast experience in the foreign exchange market, handling treasury operations, including trading and advisory desk in Union Bank of India for more than nine years, trading in spot USDINR and other major currencies like Euro, GBP, and Yen. After acquiring a degree in commerce, he took masters in Bank Management. He has also done CAIIB from Indian Institute of Bankers. Mr Mittal appears regularly on television channels and is a regular contributor to the print media. His articles have appeared in newspapers and business magazines. He has been conducting regular seminars, awareness and training programmes for clients, branches, business partners, etc. Mr Mittal is a regular speaker in seminars conducted by Commodity Exchanges, Indian Chamber of Commerce (ICC), CNBC investor camps, etc.

Since the concept of commodity futures trading got an overwhelming response in India from different sections of people like investors, traders, arbitragers, hedgers, and speculators, some are using this market as an alternate investment avenue and portfolio diversifier while some others are using this as a price risk mechanism...

Ever since the dawn of civilization, commodity trading has become an integral part in the lives of mankind. In the early days, people used barter system, i.e., exchanging goods for goods. With the advancement of civilization, trading system has gone through various changes. The history of commodity futures trading can be traced back to 1688 with the introduction of futures trading in rice in Japan. This was followed by an increased participation in commodities derivatives, especially futures, in the industrialized countries like the US and UK. The commodity derivatives markets in India are as old as those of the US. The commodity derivatives markets in India dates back to 1875 when the Bombay Cotton Trade Association was set up to start trading in cotton futures. Subsequently, many other associations have started futures trading in commodities, such as oilseeds in Bombay in 1900, raw jute and jute products in Calcutta in 1912, wheat in Hapur in 1913, bullion in Bombay in 1920. However, in 1939, the options trading in cotton was banned by the Government of Bombay to restrict the speculative activity in the cotton market. In subsequent years, forward trading in various commodities like oilseeds, food grains, vegetable oils, sugar and cloth were also prohibited.

Organized Commodity Derivative Trading

India’s commodity exchanges have come a long way since their inception. In India, there are four national-level exchanges: Multi Commodity Exchange of India Limited (MCX), National Commodity and Derivatives Exchange Limited (NCDEX), National Multi Commodity Exchange of India Limited (NMCE), and Indian Commodity Exchange Limited (ICEX). Apart from these four exchanges, nearly 19 regional commodities exchanges are in operation, dealing with specified commodities in the respective region. With the success of commodity trading, more commodity exchanges are emerging in India. ICEX came into existence in late 2009 and two more exchanges are likely to commence their operations soon. Besides futures trading, the commodities found their place in the form spot exchanges (NSEL and NSPOT) to serve the needs of physical traders.

Growth

Since the inception of futures trading in commodities, the market grew manifold till date. The turnover of both MCX and NCDEX combined together grew from a mere Rs 2.45 trillion in 2004 to Rs 62.40 trillion in 2009. The year-on-year (YoY) growth was tremendous since its inception except in 2007 when the commodity market saw some setback in the form of ban in futures trading in commodities like urad, tur, wheat and rice. Due to suspension in trading, the turnover growth was limited. However, in subsequent years, market managed to overcome these bottlenecks. Increased awareness among the



offer another option. Commodities offer immense potential to become a separate asset class for market-savvy investors, arbitragers, and speculators. Commodities are accepted as a separate asset class with a unique and distinct source of return. It is well documented that the statistical properties of commodities yield important risk reduction benefits for a portfolio, which is invested mainly in financial assets. The commodity markets are negatively correlated with those of traditional financial assets. An investor can take full advantage of the unique statistical properties of commodity investments in their portfolios by adding commodity assets.

Indian Commex Tornover (in Rs Trillion) 70 60 50 40 30 20 10 0

2004

2005

2006

2007

2008

2009

Commodities: An Alternate Asset Class

investors about the market and its usage led the Indian market to show dramatic rise. In 2009, based on the number of contracts traded on exchanges, MCX has emerged as the sixth largest exchange in the world. This will increase confidence among the Indian investors to invest in the commodities market.

Asset Class

2009 (1 Yr)

2007-09 (3 Yrs)

2005-09 (5 Yrs)

Gold (MCX)

22%

80%

165%

Gold (Comex)

24%

72%

150%

Silver (MCX)

46%

38%

157%

Silver (Comex)

47%

30%

145%

INR Currency*

-5%

5%

7%

Top Commodity Exchanges Based on Number of Contracts Traded (million contracts)

EUR Currency

-3%

-9%

-6%

Rank

Sensex

81%

27%

165%

1

Exchanges Shanghai Futures Exchange

Jan-Dec 2008

Jan-Dec 2009

% Change

140.26

434.86

210.03

Dow Jones

19%

-16%

-3%

India - 10 yrs. Govt. bond

7%

8%

7%

US - 10 yrs. Govt. bond

3%

4%

4%

2

CME Group (CBOT & NYMEX)

513.42

420.66

-18.07

3

Dalian Commodity Exchange

319.16

416.78

30.59

4

Zhen Zhou Commodity Exchange

222.56

227.11

2.05

5

Intercontinental Exchange (includes US, UK and Canada)

198.67

207.23

4.31

6

MCX

94.31

161.17

70.90

7

London Metal Exchange

105.86

106.46

0.57

MCX has become the largest exchange in the world in silver; the second largest in gold, copper and natural gas; and the third largest in crude oil futures; in terms of the number of futures contracts traded during the calendar year 2009. NCDEX does more volume in agricultural commodities such as oil and oilseeds, spices, cereals, and pulses.

Commodities: An Investment Avenue

Commodity markets provide huge investment opportunities for the investors. There was a traditional belief that investing in the financial assets is good because it provides better returns to the investors, but this notion of investors is changing slowly. For investors who want to diversify their portfolio beyond shares, bonds, and real estate, commodity markets

Note: Yearly returns are for calendar years * (-) means appreciation versus dollar

Need for Development of Commodity Derivative Market in South Asia Since the concept of commodity futures trading got an overwhelming response in India from different sections of people like investors, traders, arbitragers, hedgers, and speculators, some are using this market as an alternate investment avenue and portfolio diversifier while some others are using this as a price risk mechanism.

As far as gold is concerned, the South Asia region has only one name to talk about, i.e., India. India is world’s largest gold consumer and importer as well. India is the net importer of both gold and silver with an estimated annual demand of 600-800 tonnes of gold and 3,000 tonnes of silver. In terms of futures trading, India undoubtedly ranks first in South Asia. Talking about base metals, India ranks higher compared to other countries in South Asia. There is hardly any contribution by these nations

INDIA

to the demand and supply or production and consumption pattern of the world. Of the countries in South Asia, India figures among the top five consumers of crude oil in the world with a daily consumption amounting to three million barrels. Pakistan is the second largest consumer in the region with a daily consumption nearing 400,000 barrels while other economies like Bangladesh and Sri Lanka have consumption below 100,000 barrels per day. The region has approximately between 0.5 to 1 percent of the world’s proved reserves of oil. The region, which is a net importer of oil, gets most of the crude from the Middle East. Like India, other countries in the South Asia region are the leading producers or consumers or exporters or importers of one or more agri-commodities. For instance, Bangladesh is one of the leading producers of jute, potato and spices; Pakistan produces wheat, cotton and sugar, Nepal produces small berry pepper and rice; Maldives produces spices and few pulses; Bhutan produces spices, potato and maize and Sri Lanka produces rubber and pepper. This gives an opportunity for establishment of commodity derivatives market in the South Asia region. India is a major producer, consumer and exporter of turmeric (80 percent), while other producers are Bangladesh (three percent), Myanmar (four percent) and Sri Lanka (two percent). India’s share in chilli production is 36 percent, followed

by Bangladesh (eight percent), Pakistan (six percent) and Myanmar (three percent). India is the largest producer of chana and contributes to 64 percent of the total global production and it is the largest consumer and importer also, while Pakistan is the third largest producer and contributes nine percent of the total production.

Conclusion

The commodity futures trading in India is a success story. The other nations in South Asia should follow this model as these countries are having huge potential as far as trading in agricommodities is concerned. Due to bilateral trade agreement, the countries in the region are doing import and export of commodities. For instance, India imports jute from Bangladesh, small berry pepper from Sri Lanka for oleoresin, export wheat, sugar and cotton when production is in surplus to Pakistan and Bangladesh. The traders, importers, exporters and the government in the region will be benefitted by setting up of commodity exchanges in the region, which can act as efficient platforms for price risk management. It is observed that whenever there is deficit of any produce in any of the countries in the region, the supplying country will start raising price of the commodity, which results in huge rise in price in the domestic market. In order to avoid this, it is necessary to establish commodity exchanges in the region.


INDIA

A Regulator Is Needed for Fixed Income Markets

S Ramesh Kumar

Head, Fixed Income Securities and Foreign Exchange Asit C Mehta Investment Intermediates Ltd

S Ramesh Kumar began his career as a probationary officer in Canara Bank. Later, he joined Citibank as manager, handling money markets, especially government securities. At Citibank, he went on to become vice president and local currency group head. Mr Kumar also held senior positions such as chief executive officer, Reliance Capital, and chief executive officer, Times Guaranty. He has attended various training programmes conducted in global financial centres such as Boston, Lagos, Philippines, Singapore, Hong Kong, etc. Mr Kumar is a visiting faculty at UTI Institute of Capital Markets, National Institute of Bank Management, and Bankers Training College. He is a graduate in commerce and holds CAIIB diploma.

The fixed income market presents an enigmatic picture with a sophisticated infrastructure for the government securities market that is dominated by the banking system! The electronic trading settlement, clearing and settlement mechanism, and margining system for the inter-bank participants and the primary dealers compare well with the developed markets.

The Planning Commission estimates and policy directions aim at a sustained growth of the Indian economy—a GDP growth rate of above 7 percent. The Prime Minister envisages a GDP growth rate of 10 percent. The financing of growth will need a well-developed equity market and bond market, in addition to banking and institutional arrangements to attract domestic savings and international investments. The investments in infrastructure and housing would involve allocation of capital by the government and the private sector through institutional and market mechanism to meet the long-term financing needs. The financial system in India is dominated by banks and equity markets (80 percent) and the fixed income market is around 20 percent of the financial system. The bond market measures at 36 percent of GDP. This is much smaller compared to the Korean bond market (114 percent of GDP) and East Asian economies (54 percent of GDP). The households and firms depend heavily on the banking system to finance their activities. A well-developed bond market is essential to meet the financing requirements of infrastructure, housing, local municipal bodies, and specialized institutions. The fixed income market presents an enigmatic picture with a sophisticated infrastructure for the government securities market that is dominated by the banking system! The electronic trading settlement, clearing and settlement mechanism, and margining system for the inter-bank participants and the primary dealers compare well with the developed markets. The bond market is dominated by the government securities market (90 percent) and the corporate bond market represents a meagre 2 percent. The primary dealers have operated as leveraged institutions, intermediating between the issuer and banks instead of becoming throughput institutions to distribute the securities among a large number of investors. This had resulted in primary dealers making large profits when the interest rates were falling and have to be closed or merged when the interest rates were rising. The government securities are issued in a transparent manner through the auction process with the RBI as the manager of public debt and the primary dealers participating on a committed basis. The calendar for borrowings is being announced in a systematic manner to avoid surprises. However, the secondary market trading is restricted to a few



‘benchmark’ securities with lack of liquidity in other securities. The ‘balance sheet’ requirements of banks formed the basis for allocation of securities into HTM (held to maturity), AFS (available for sale), and HFT (held for trading) categories affecting the supply and demand of securities in the secondary market. Banks, insurance companies, provident funds, and mutual funds participate in the government security market. There is virtually no retail participation as the fixed income investment of individuals is allocated toward non-tradable government savings bonds and fixed deposits of post office savings banks and nationalized banks. The money market activities are predominantly overnight markets. The volatile cash flows are being absorbed by the RBI on a daily basis, making the banks lazy and passing on the cash management activity to the central bank! The certificate of deposits of banks acts as surrogate to term markets. CBLO (collateralized borrowing and lending obligation) is a unique mechanism that moves large volume of money on a secured basis. The market repo in government security is yet to develop as a significant instrument for cash management. RBI has issued guidelines for repos in corporate bond markets with a haircut of 25 percent and further reserve requirements in the form of CRR/SLR on the borrowings that make the borrowings least attractive for banks and financial institutions. There has been growth in the number of money market mutual funds, with favourable tax breaks, that invest in CD, commercial paper, short-term debentures, and bankers’ acceptances. These entities attract the surplus of domestic corporate and overseas investments for tax and interest rate arbitrage. There is a limit on FII investments in the debt market (currently $15 billion). FII may invest directly in the debt instruments or through money market/debt mutual fund. The size of the corporate bond market is around 2.3 percent of the financial system, which includes corporate issuances and securitized instruments. The primary market has been largely in the form of private placements to qualified institutional investors. There has been increase in the number of public issuances by non-banking finance companies to finance their lending operations. There has been issuance of index-linked bonds to capture upside in the earnings linked to Nifty and protect the principal investments. There is urgency among the policy makers to develop the corporate bond market to meet the financing requirements. The legal and

regulatory framework is through a high level committee of RBI, SEBI and IRDA for bond and money market is not comprehensive. The approach of RBI— ‘whatever that is not permitted is prohibited’—inhibits innovation in the marketplace. Further, the RBI, being the intervening regulator in the money market and currency market, is more concerned about the stability of the financial system resulting in ‘control’ of the entities instead of ‘regulating’ the markets. India has a well-developed banking system and equity markets, regulated well by the RBI and SEBI respectively. In the fixed income market, the money market is regulated by the RBI and the bond market is regulated by SEBI. There is a need to have a market regulator for the fixed income market to provide comprehensive guidelines and monitor the activities in a systematic manner. The market infrastructure of stock exchanges, clearing houses, credit rating agencies are readily available. The participant’s narrow interest and regulatory guidelines continue to permit opaque transactions, and homogeneous risk profile of the investors results in inefficient markets. The banks have to develop a term market in the short run with better cash management and insurance companies and mutual funds must play a larger role in developing a long-term yield curve on the basis of risk-free government securities issued. There is a need for more diverse issuers like housing companies, local government entities and municipal corporations, infrastructure companies, small and medium enterprises for long-dated instruments. Mutual funds have to become entities to pool resources with different risk profile instead of arbitraging on tax benefits for the markets to grow. Securitization instruments and STRIP of government securities may provide simple instruments for retail investors across different tenors. The FII investment in debt markets is limited to $15 billion. The public sector companies are the large issuers while the private sector depends on bank borrowing and external commercial borrowing to finance their activities. To meet the large requirement for financing the growth, the current dependence on banking system will become increasingly difficult and the regulatory focus will be to de-risk the intermediaries. There is an urgent need for the legal and regulatory requirement to become responsive for developing a robust fixed income market for efficient allocation of resources from domestic savings and global investors.

INDIA

ETFs Have More Potential in India

Rajan Mehta

Executive Director & Co-Founder Benchmark Asset Management Company

Rajan Mehta has vast experience in Investment Management. Prior to the present venture, he was Vice President at Merrill Lynch, London and Vice President at DSP Merrill Lynch. He holds a BE in Mechanical Engineering. Mr Mehta is an alumnus of L N Wellingkar Institute of Management Studies and London Business School.

The challenge the industry faces is to deliver quality financial solutions to masses with profitability. With ETFs as the main underlying engine for financial solutions, it is possible to develop scalable and profitable delivery model for quality financial advice...

Exchange-Traded Funds are a major fund structure in the world with more than $1 trillion of assets under management. The reason for its stellar growth can be attributed to various advantages that ETFs offer, such as transparency, efficiency, lower cost, equitable structure, and ability to cover a vast number of assets. Many financial advisors say that constructing an entire portfolio of ETFs is an efficient way to deliver wealth management solutions. A fee-based ETF portfolio allows flexibility of charging fees based on the level of service rather than embedding the fee into the product and a one-price-fits-all solution. Apart from these factors, ETFs offer some additional advantages for the Indian market. Firstly, the Indian investment market is geographically vast and fragmented. For each mutual fund, setting up its own servicing infrastructure is costly. Secondly, at retail level, payment systems are not very efficient and there are time lags from smaller centres. One of the main drivers of launching ETFs in India is to leverage the reach of trading and payment mechanism of National Stock Exchange (NSE). This has been vindicated to an extent as we have no investors in over 550 towns, right from Srinagar to Port Blair. This leveraging has been achieved with only four offices across India. Another factor that makes ETFs more relevant to India is ecosystem of financial advice. There has been rapid growth in the number of professionals offering advice, but the penetration of financial products is less and there is ample scope for improvement. The challenge the industry faces is to deliver quality financial solutions to masses with profitability. With ETFs as the main underlying engine for financial solutions, it is possible to develop scalable and profitable delivery model for quality financial advice. This will gradually unfold as more ETF products are offered and reinventing of business models by financial advisors gains speed. All the above factors led to the introduction of ETFs in 2001. The first ETF, Nifty BeES, was launched in end-2001 and listed on NSE in January 2002. India was the first country in Emerging Asia to start ETFs. Since then many new and different categories of ETFs have been introduced. Currently, seven asset management companies offer around 20 ETFs. Most of them are listed on NSE and they also trade on Bombay Stock Exchange (BSE) as permitted securities. In terms of underlying index/asset classes, they can be classified in the following categories.



ETFs on Diversified Equity Indices:

These are ETFs based on broad market indices like S&P CNX Nifty, Sensex, and Nifty Junior.

ETFs on Sector Equity Indices:

These are ETFs on sector equity indices like Bank Nifty Index and PSU Bank Index.

ETF on Ethical Equity Index:

This is a faith-based ETF called Sharia BeES, based on Nifty Sharia Index.

ETF on Money Market:

This is a money market ETF called Liquid BeES. When it was launched, it was the first of its kind in the world. It allows stock brokers to run a virtual sweep account for their clients.

ETFs on Gold:

The first ETF on gold in India was Gold BeES. It was launched in 2007. Since then, this category has seen tremendous growth. Currently there are seven gold ETFs. This category represents the highest assets, one of the large trading volumes, and the highest retail penetration among all categories of ETFs.

ETFs on International Equity Index:

The first such fund, Hang Seng BeES, was listed on NSE recently. Nifty BeES, Gold BeES, and Liquid BeES are ranked in the top 150 scrips on most of the trading days. The fund category has come to stay as awareness is spreading slowly and gradually and the ecosystem is developing. NSE and BSE have launched separate ETF trackers on their website. A leading business daily, Economic Times, has started reporting ETFs trading separately. A series of training programmes have been conducted to popularize ETFs and the awareness level is increasing

gradually. The number of brokers participating in ETF trading has grown to more than 600, which is a significant increase. Recently, NSE has announced incentives by waiving off/reducing transaction charges on some categories of ETFs.

Challenges

Like any business, ETFs also have had its challenges and growth has been slower to some extent due to the challenges. Revenue Model: One of the major challenges for the growth of ETFs in India and elsewhere in the world has been the revenue model for distributors/financial advisors. This industry is built upon receiving income from the product providers who in turn embeds it into the product itself. ETFs work on a model where the advisor charges customer separately and the product provider does not give any commissions to the intermediary. With new regulatory regime, most of the advisors have been nudged towards this model but the changes will be slower initially and will gather speed once critical mass has been acquired under this model. Philosophy of Indexing: Another major challenge is that the concept selling has to be done for indexing as well for ETFs, which slows the process. Unlike in the US where indexing had become popular prior to introduction of ETFs, in India it was not that popular.

Road Ahead

New ETFs will be introduced in the coming months and years. They will probably represent more equity sectors, more international indices, and fixed income. Though there is a good underlying demand for commodity ETFs, the current regulatory framework makes it extremely difficult to structure legally viable commodity ETF. Also, with increased efforts on awareness creation and with business model changes of financial advisors, the Indian ETF industry is set to emulate the global ETF industry.

MALDIVES

Maldives Stock Exchange (Pvt.) Ltd

MALDIVES

Development of Capital Markets

Fathimath Shafeega Chief Executive Officer Capital Market Development Authority

Ms Shafeega was appointed the CEO and member of the Board of Directors of the CMDA in 2006, when the Authority was established. Earlier, Ms Shafeega served as a Deputy Managing Director of the Maldives Monetary Authority. Ms Shafeega has taken the initiative to develop the capital market in Maldives and to promote investor education and awareness. She has led the transformation of CMDA from a division functioning within the Maldives Monetary Authority into an independent institution. Ms Shafeega was instrumental in starting the CMDA Code of Corporate Governance for listed companies. She is a postgraduate in Banking and Finance from Monash University, Australia.

If the Maldives is to achieve its ambition of having a thriving capital market, which finances business investment and development and promotes the expansion of the Maldivian economy, it needs to tap onto the experience, knowledge, and expertise of other jurisdictions...

Background

The history of the Maldivian capital market dates back to the early 1960s when a small number of companies raised money from the public for economic activities. The capital market remained unregulated and little was done to promote or develop it until 1999 when a Capital Market division was established within the Maldives Monetary Authority. This move, as a result of the awareness of the potential for growth in the economic sector, laid the foundation for future capital market activities in the Maldives. The Capital Market Development Authority (CMDA) was established in 2006 under the Maldives Securities Act, 2006. The CMDA is a statutory agency responsible for regulating and facilitating the development of an orderly, fair, and efficient capital market in the Maldives. It plays a critical role in the economy by facilitating mobilization and allocation of capital resources to finance long-term productive investments. During its inception, the CMDA was entrusted with a legal mandate to manage the Securities Trading Floor, which was performing the role of the Stock Exchange and the Securities Depository. However, in 2008, the Securities Trading Floor and the Securities Depository were separated from the CMDA and established as Maldives Stock Exchange Company Pvt. Ltd. (MSE) and Maldives Securities Depository Company Pvt. Ltd. (MSD), which became private sector institutions licensed under the Securities Act. In addition to licences granted to MSE and MSD, dealer’s licence was granted to three firms (Stockbrokers Maldives Pvt. Ltd., First Option Pvt. Ltd., and Aariya Securities Pvt. Ltd.), and dealer’s representative licence was granted to seven individuals. The CMDA has also prepared a draft regulation governing investment advisors and is getting ready to licence investment advisors. There are four companies listed on MSE—Bank of Maldives Plc, Maldives Transport and Contracting Company Plc (MTCC), State Trading Organization Plc (STO), and Maldives Tourism Development Corporation Plc (MTDC). All the four companies are the result of privatisations.

Vision

The vision of CMDA is to create a thriving capital market that finances business investment and development and promotes the expansion of the Maldivian economy.


Maldives Stock Exchange (Pvt.) Ltd

Mission

The mission of CMDA is to facilitate fair and orderly development of the capital market so that businesses have access to capital and at the same time investors are provided with investment opportunities.

Core Values

The CMDA will be guided by the following core values to fulfil its mandate, pursue its vision, and accomplish its mission: • • • •

Ethics, fairness, honesty, and integrity are the cornerstones of market regulation High levels of professionalism in work Market regulators will be accountable to the government, the Board, and the stakeholders The Authority shall be operationally independent from external, political, or commercial interference in the exercise of its functions and powers

Strategic Initiatives

Against the backdrop of changing economic environment in the Maldives, the CMDA is taking the initiative to implement the first Capital Market Strategic Plan covering the next four years. The Capital Market Strategic Plan 2010-14 outlines the strategic activities the Authority will undertake during the plan period to define the strategic direction of the capital market in the next few years. The Strategic Plan activities are within the Authority’s mandate of developing and regulating the capital market. The CMDA has set ten strategic objectives, the attainment of which will contribute to the achievement of its goals for the capital market. These objectives are: 1.

2.

3.

4.

Establishment of a robust, supportive, legal, and regulatory framework that conforms to international best practice. The objective will involve review of the existing legal and regulatory framework and establishment of new legislation meeting internationally accepted standards. Development of capital market products and services. This objective will be achieved by attracting new companies to list on MSE, broadening the range of products and services with a strong focus on SME and bond market development, increasing the level of savings and investments, facilitating the introduction of domestic and institutional investors, and advising the government on policies that impact the capital market. Empowerment of investors and issuers to make informed decisions. The objective will be achieved through increased promotion, investor education and awareness, and enhancement of public understanding of the capital market and investor rights. Enhancement of capital market infrastructure and institutional arrangement. The objective will be achieved by strengthening

the market structure, including introducing new types of licences and supporting MSE and MSD to become effective self-regulatory organizations. 5. Strengthening the managerial capacity of capital market institutions and intermediaries. This objective will be accomplished through enhancement of good corporate governance practices and promotion of professional and managerial capacity of market intermediaries and licensed institutions. 6. Enhancing effective and efficient utilisation of Information Technology. The objective will be achieved by the development and implementation of an IT strategy for the capital markets. 7. Building strategic alliances. The objective will be accomplished by promoting and pursuing cooperation with other securities organizations, markets, and regulators. 8. Pension supervision. The objective will be accomplished by the development and implementation of an effective mechanism for the regulation of the pensions industry. 9. Strengthening the institutional capacity and image of the CMDA. The objective will be accomplished by capacity building and minimizing the response time in addressing industry and investor enquiries so as to build and strengthen the image of the CMDA; balancing costs and revenue in order to strengthen the financial base and reduce the amount of annual government subvention; and enhancing internal systems, policies, and procedures. 10. Development of high-performing human capital and promotion of positive corporate culture. This objective will be accomplished by having in place qualified and trained professionals experienced in the regulation of securities markets, adopting an integrated approach to human resource management, and promoting a positive corporate culture. If the Maldives is to achieve its ambition of having a thriving capital market, which finances business investment and development and promotes the expansion of the Maldivian economy, it needs to tap onto the experience, knowledge, and expertise of other jurisdictions. Globalization is leading to closer cross-country linkages among the capital markets. It is becoming necessary to coordinate and harmonize regulatory standards with other countries to obviate the scope for cross-country risks, particularly with the ongoing cross-border listing initiatives. The Maldives should have the ability to engage strategically at the international level. This requires greater engagement at regional and international level through bodies such as the South Asian Association for Regional Cooperation (SAARC), the South Asian Securities Regulators Forum (SASRF), and IOSCO, of which the CMDA will become a member in June 2010. Working closely with SAARC and others on cooperation and harmonization presents possible opportunities for future expansion of the market and the possibility of introducing new financial products and market development initiatives.

MAURITIUS

Global Board of Trade Ltd The Stock Exchange of Mauritius Ltd

Exchange Industry

Other Asset Classes

Exchanges


Proposed

Commodity Markets

N/A

Stock

Number

1

Capital Markets

Banking

Regulator

Name

Financial Services Commission

Regulator

Name

Bank of Mauritius

Brokers

Number

10

Scheduled Commercial banks

Number

18

Registrars

Number

25

Private Sector

Number

6

Custodians

Number

5

Foreign

Number

12

Depositories

Number

1

ATMs

Number

382

Demat Accounts

Number

55,500


%

66

Securities Accounts

Number

250,000

Capital Adequacy Ratio (2009) %

15.30

Companies Listed

Number

89


%

5.75


$ mn

6,361

Prime Lending Rate

%

9


%

40.5

Bank Assets to GDP

%

0.30


%

61


Turnover (2009)

$ mn

409.4

Regulator

Name

Financial Services Commission


%

5

Fund Houses

Number

2


72.1


11.5

Products Offered

Equities, T-Bills & Debentures

Settlement Cycle

T + ….

T+3

MAURITIUS

Centralized Clearing of OTC Derivatives: Panacea or New Problems? Joseph Bosco

Deputy Managing Director & Chief Operating Officer Global Board of Trade

Joseph Bosco is the Deputy Managing Director and Chief Operating Officer of GBOT. Mr Bosco is a qualified professional in Finance, Law and Compliance with over 34 years experience in Banking and Capital Markets. He has held top positions in this field, including that of MD & CEO of OTCEI and Head of an independent Listings Authority in an international exchange in Dubai. Earlier, while at National Stock Exchange (NSE), Mr Bosco headed the departments of Membership, Listings, Inspection and Corporate Communications. In 2004, while working with ICICI Securities, he established the Legal and Compliance departments. Mr Bosco holds a degree in Law and is an MBA in Finance from XIM, Bhubaneswar, and he is a graduate professional in Regulations and Compliance (CRCP) for the US Securities Markets from the Wharton School, University of Pennsylvania, US.

The recent global financial crisis has demonstrated need for robust risk models. There is a great difference between risk management models and valuation models. In risk management models, unlike valuation models, emphasis is on robustness of the model rather than on the degree of calibration or parameterization...

The largest bailout package in the history of the world financial markets, to the tune of $ 2.5 trillion, following bankruptcies of Lehman Brothers and Bear Stern has finally woken the US regulators to a stark reality that OTC derivative markets need better understanding and supervision. Owing to lack of information about where risks related to OTC derivatives arise and how they are distributed throughout the financial system, OTC derivatives appear to have acted as a contagion channel during the current crisis. Due to the close affinity between institutional dealers who structure and broker these OTC transactions, complications at one institution may have severe consequences on other related financial institutions. High on the agenda therefore is the clearing, risk management and settlement of the OTC transactions through a Centralized Counter Party (CCP). The existing clearing houses, mostly affiliated to the organized derivative exchanges, have already sensed this opportunity, estimated to be worth $500 trillion, and have started offering clearing services for some of the derivative transactions. The Obama administration in September 2009 presented a legislative proposal to Congress that would subject the banks that trade derivatives to new capital requirements and mandate centralized clearing for OTC derivatives. The Wall Street banks have responded by declaring ambitious targets for centrally clearing a significant part of their new CDS and interest rate derivative contracts beginning October 2009. In Europe, a group of nine banks began clearing CDS trades centrally earlier this year after the European Union threatened legislative action. Clearly, routing the settlement and risk management activities through the CCP is being increasingly recognized as a means of mitigating the systemic risk of derivative industry.

Centralized clearing platforms currently available are: 1.

2. 3. 4.

CME Group Inc.’s ClearPort platform provides central counterparty clearing for bilateral OTC trades. It has added more than 175 new products to the ClearPort platform this year alone, including swaps on corn, electricity and natural gas; the Exchange is also planning to clear derivatives based on equities, foreign exchange, credit, interest rates and weather. Eurex clearing provides a similar service. LCH Clearnet has announced the planned extension of its proven OTC interest rate swap clearing service, SwapClear, to the broader buy-side trading community. The Depository Trust and Clearing Corporation (DTCC) in the US also provides deal



5.

registration, risk management, and central clearing services. Bclear, the clearing service offered by NYSE Liffe, clears the vanilla OTC futures and options based on liquid stocks, agricultural commodities, and equity indices.

US Congress is yet to decide which of the above routes could be adopted for the OTC clearing for products initiated in the US. A few possible causes of concern for routing the clearing/ settlement functions through a Centralized Counter Party are highlighted below: 1. The CCPs may not be able to process all the OTC transactions The popularity of OTC derivatives is at least in part due to the market’s capacity to tailor instruments to reflect precise risk exposures. Tailored instruments do not succeed on exchanges because the number of participants interested in trading the same tailored exposure is likely to be quite small, certainly not enough to justify an exchange listing. CCPs may have the knowhow to deal with the settlement risks resulting from transactions related to their own standardized contracts, but will they have the same expertise to value and settle the complex and tailored OTC transactions from the trade date till the obligations are executed? A somewhat intermediate solution to this situation is provided by NYSE Liffe’s Bclear, its clearing service for equity derivatives. Bclear is a web-based service for registering wholesale equity derivatives trades for confirmation, administration and clearing. With Bclear, the users do not have to worry about the paper confirmation of the deals, following the ISDA format or the legal costs. The service allows flexibility to specify contract maturity, exercise price and settlement method on futures and options on blue-chip single stocks, national and pan- European indices. Since the first quarter of 2009, Liffe has started offering cash-settled OTC futures and options priced against the benchmark Robusta Coffee, Cocoa and White Sugar Contracts already traded on Liffe, for clearing through Bclear. The service is, of course, helped by the easy availability of daily updated prices of the underlying securities and commodities, because what is being made available for clearing in the OTC derivative space currently is based on only the most liquid stocks, indices and commodities, where undisputed settlement prices are available. In fact, except for the maturity date, everything is in line with the standardized contract, making matters easier for the CCP. But a large majority of the products that are offered by banks and other such entities do not fall under this category and hence this is only a limited solution.

2. Settlement of long maturity products Generally interest rate swaps have long-term maturity often exceeding 10 years. Even with the assumption that CCPs have accurate valuation models for these contracts, problems are bound to surface because of illiquidity over the term of the product and the lack of reliable data for simulations over this prolonged period. Also, counterparty risk might escalate as frequent marking to the market over the term of maturity of the product might not occur on a regular basis. One possible solution could be to deter banks and large institutional investors (who are licensed by different regulators) from taking positions for maturity periods greater than five years. Since banks and investment bankers are guided by the Basel II norms, these institutions have to comply with the risk weightage attached with each investment. Thus, if the risk weightage attached with all OTC derivatives having a maturity greater than five years is sufficiently high, it would act as a deterrent for these institutions taking positions in such long maturity products that are difficult to evaluate. Similar disincentives can be brought in for other market participants. The market regulator can affix certain predefined percentages for exposures in OTC derivative products for market participants. Within this fixed percentage, market participants can take positions in longterm as well as short-term products but the cap for the long-term products can be pegged at sufficiently low levels. Thus, bringing a vast majority of OTC derivatives under short-term maturity and enabling better control by CCP and easier calculation of valuation models. 3. Lack of common valuation models Presently, valuation models for each party to an OTC transaction differ depending on the valuation model being used. For example, credit derivatives wherein each dealer firm has its own valuation model. Hence, attempting to provide a common valuation model would be a difficult task for the CCP. One possible solution could be to make both the parties to the deal agree to a common valuation model. However, this solution too is not as simple as it appears since agreeing to a common valuation model by each party would only be the first step. Thereafter, all involved parties in the secondary market including the CCP will have to provide for the intricacies involved in actually deploying the valuation model. Catering to different computational requirements of different deals may also not be straight forward for the CCP.

4. Lack of risk management models The recent global financial crisis has demonstrated need for robust risk models. There is a great difference between risk management models and valuation models. In risk management models, unlike valuation models, emphasis is on robustness of the model rather than on the degree of calibration or parameterization. Presently, there are no sophisticated risk management models available on plug and play basis for exotic OTC derivative products. These models have to be developed as the first stage before going for CCP. 5. Compromising the process of financial innovations One of the prime objectives for OTC transactions is to provide flexibility to the market participants. Reducing the maturity period and bringing in standardization would defeat the very purpose for OTC derivatives and might signal the end of financial innovations in OTC products. However, this flexibility should not come at the expense of compromising risk management and valuation models. There should be a fine balance of innovation and transparency in OTC products since it must not be forgotten

that in case of failure of any innovative product, it is the masses who are the ultimate sufferers as recently witnessed during the financial turmoil. 6. Concentration of systemic risk Exchanges and clearing houses are globally recognized as two of the pillars of financial infrastructure for any country since these institutions operate as utility companies used daily by the general public. Moreover, these financial institutions are capital intensive and require sufficient time to build reputation. Thus, similar to typical utility companies, their numbers are limited. Hence, with OTC trades also being cleared through handful CCPs and the number of transactions being cleared through a single CCP being very large would create concentration of risk at the CCP level. This gives birth to a new risk in itself. Thus, even though, presently, OTC derivative clearing through a CCP for all the OTC products introduced into the markets might be fraught with difficulties and unwelcome by certain sections of the market, it is nevertheless the logical way forward and regulators should encourage centralized clearing for the vast majority, if not for all derivative products.


MAURITIUS

The Stock Exchange of Mauritius: Evolution and challenges Sunil Benimadhu Chief Executive Stock Exchange of Mauritius Ltd.

Sunil Benimadhu has held various positions in the Securities industry. He has played an instrumental role in uplifting the infrastructure of the SEM. Mr Benimadhu has also spearheaded the project to enable the SEM join the World Federation of Exchanges. He was a member of the Executive Committee of the South Asian Federation of Exchanges (SAFE) from 2002 to 2004. From 2001 to 2003, he was the Chairman of the SADC Committee of Stock Exchanges (COSSE), an association of stock exchanges, including ten exchanges of the Southern African region. Mr Benimadhu is also a regular speaker on emerging markets and on African markets in international stock exchange conferences. Before joining the SEM, Mr Benimadhu worked in the Treasury Department of the African Development Bank (ADB) and was the General Manager of the National Mutual Fund Limited in Mauritius. He holds an MBA in Finance and Investment from the University of Illinois, United States as well as a DEA in Development Economics and a Maîtrise in Macroeconomics from the University of Aix-Marseille, France.

The SEM has also taken a number of initiatives in recent years, which raised its visibility and profile and placed it on the radar of a growing number of international institutional investors from different regions of the world...

The Stock Exchange of Mauritius Ltd (SEM) has come a long way since the first trading session took place on July 5, 1989. It is time to reflect on some of the salient undertakings that have contributed to the shaping of the SEM and, more importantly, probe into the key strategic shift that should underpin SEM’s near-term policies as it takes up new operations.

SEM’s Evolution

The SEM started its operations as a small pre-emerging exchange and has evolved over the years into one of the leading exchanges in Africa. Today, the Exchange operates two markets: the Official Market and the Development & Enterprise Market (DEM). The Official Market, which started its operations in 1989 with five listed companies and a market capitalization of nearly $92 million, has 38 listed companies with a market capitalization of nearly $5,082.96 million as on January 29, 2010. The DEM was launched on August 4, 2006, and there are 49 companies listed on this market with a market capitalization of nearly $1,588.43 million as on January 29, 2010. The SEM underwent the following changes during the last two decades. 5 July 1989 No. of listed securities (Official + DEM) 6 Market capitalization (Official + DEM) (Rs bn) 1.4 Market capitalization as a % of GDP 2.5 * Total value traded (Rs mn) 50 * No. of trading days per annum 51 Trading system Manual Settlement cycle Physical, T +10 Internet trading N/A Ownership structure Mutualised Disclosure requirements Limited Reporting cycle Half-yearly Website N/A

*Periods covered: July1989-June 1990, January 2009-December 2009

5 February 2010 100 207.1 75 12853 250 Automated Trading (ATS) Demutualised, DVP, T+3 I-net Demutualised/Public Company Extensive Quarterly Highly informative

Leading the innovative thrust in the Exchange space on the continent, the SEM was the first exchange in sub-Saharan Africa to move away from a manual trading/clearing and settlement environment to an electronic stock exchange infrastructure that replicates



the functionalities and operating features of the stock exchanges in the developed countries. The SEM has in place a world-class stock market infrastructure that enables investors, in Mauritius and outside of Mauritius, to follow the evolution of the market in real time, access the order book of listed companies in real time, and trade online to capture the market opportunities in a dynamic market environment. The SEM has also taken a number of initiatives in recent years, which raised its visibility and profile and placed it on the radar of a growing number of international institutional investors from different regions of the world. The implementation of new disclosure-based listing rules, which draw heavily on rules prevailing in jurisdictions well known for their focus on full and timely disclosure of important information, the demutualization of the ownership structure of the Exchange, the graduation of the Exchange to the status of full-membership of the World Federation of Exchanges, the extension of trading hours into the afternoon, the setting up of the DEM market for small and medium-sized companies, and the implementation of turn-around trading are some of the salient changes that have been implemented in recent years to revamp the operational environment in which the SEM operates. These initiatives, among others, enabled the SEM to obtain the runner-up position of the “Most Innovative Exchange Award” organized by Africa Investor in 2007. On the performance front, right before the on-start effects of the global crisis in February 2008, the SEM experienced a strong bull run in the October 2002-February 2008 period, during which the total return index, SEMTRI, grew by an astounding 650 percent in dollar terms on the back of double-digit growth achieved by the bellwether listed stocks and key structural economic reforms implemented by the government to position Mauritius as an attractive place for doing business. The economic reforms have enabled Mauritius to gain the top spot on the World Bank list for ease-of-doing-business in Africa. Likewise, the solid performance of the Mauritius stock market in recent years attracted growing inflows of funds into the market from foreign institutional investors (FIIs), who account of about 40 percent of the daily trading volume. The growing interest from international investors has prompted well-known index and data providers like Standard & Poor’s, Morgan Stanley, Dow Jones, and FTSE to include the SEM in a number of new indexes they launched over the last couple of years to track the evolution of some key frontier emerging markets. SEM also went live on Bloomberg since 2009 and is among the three stock markets in Africa, besides South Africa and Egypt, to be included in the list of stock markets that Bloomberg is tracking live on a daily basis. This live coverage of the SEM on Bloomberg and global index providers constitutes a positive step that will enhance the SEM’s visibility at the international level and accelerate the Exchange’s integration within the international financial markets.

Challenges and Responses

The substantial overhaul of SEM’s operational, technological, and regulatory frameworks during the last two decades has undoubtedly enabled it to respond to the expectations of local and international stakeholders in a better manner. As we delve into the future, our thoughts should be geared towards the strategic shifts and policies that need to be embraced in the near-to-medium term to ensure the readiness of the SEM to face the shifting landscape in the Exchange space in the region and worldwide. Our focus in the near-to-medium term should be geared towards the three Ps of the Exchange space: Products, Players and Participants. We are currently contemplating new initiatives to diversify our product base through the addition of new products to the existing product landscape. There is compelling evidence today that the listing of investment funds, specialized debt instruments, structured products, and exchange-traded funds is witnessing double-digit growth in many jurisdictions, even becoming the focus of expansion in some exchanges. In response to this mounting trend, the SEM has launched, in February 2010, a specific investment funds listing regime to cater to a variety of fund structures. Major changes have been brought to our listing rules to align them with the Collective Investment Schemes Regulations 2008 and these changes have positioned the SEM as an attractive venue for the listing of global and specialized funds. The listing régime set is based on rules that are flexible enough to cater to the specific attributes of global and specialized funds, including professional collective investment schemes, specialized collective investment schemes, export funds, etc. The SEM has a commitment to aggressive timings on processing of listing applications and has adopted a listing fee structure that is very competitive compared to other jurisdictions like Dublin, Luxemburg, Cayman Islands, etc. The SEM now intends to aggressively market the revamped listing rules with a view to position it as an attractive venue for the listing of global funds and specialized funds. We have also been working with the CDS, brokers, and other market participants on the introduction of derivatives in our market. The first futures contract to be introduced will be based on the SEM-7 index. There still remains a lot of work to gear the market up for this type of product. The introduction of derivatives trading on the SEM is expected to have a positive impact on liquidity in the underlying instruments, enhance the process of price discovery and enable investors, both retail and institutional, to manage their investment portfolios in a more dynamic manner.

Conclusion

The SEM has made some important strides in its development process since 1989 and looks well poised to undertake a number of reforms in order to contribute towards the enhancement of the operational and regulatory efficiency of our market.

NEPAL


Exchange Industry

OTHER ASSET CLASSES

Exchanges


Stock

Number

1

Commodity

Number

3

N/A

Banking

Capital Markets

Regulator

Name

Nepal Rastra Bank


Number

26

Regulator

Name

Securities Board of Nepal

Public Sector

Number

26

Brokers

Number

23


%

92

Registrars

Number

16


%

6

Custodians

Number

0

Prime Lending Rate

%

10

FIIs

Number

0

Merchant Bankers

Number

17



Number

0

Regulator

Name

Securities Board of Nepal

Depositories

Number

0

Fund Houses

Number

2

Demat Accounts

Number

0

Companies Listed

Number

171


$ mn

5882.26


%

12.67


%

56.64

Turnover (2009)

$ mn

228.08


%

-36.8


39.17

Products Offered

Equities, Government & Corporate Bonds

Settlement Cycle

T + ….

T+3

NEPAL

Capital Markets Face Regulatory Challenges

Dr Surbir Paudyal Chairperson Securities Board of Nepal

Dr Surbir Paudyal has 31 years of experience in economic research and development. He is a Development Economist with wide experience in the field of policy analysis, environmental policy development, project monitoring and supervision, tourism, and foreign trade. He is also Reader, Economics Department, Tribhuvan University, Kathmandu. He held various positions such as team leader of Tourism Master Plan of Nepal, World Bank consultant for survey on living standards in Nepal, coordinator and advisor of National Planning Commission, etc. He holds a degree in humanities and social sciences, a degree in law, MA in Economics, and PhD in Economics. He attended many training programmes on economic development and growth.

The capital market is to play a critical role for the development of infrastructure, hydro, hotel and tourism sectors to take advantage of comparative and competitive strengths and opportunities...

Introduction

The Securities Board of Nepal (SEBON) is the capital market regulator in the country and its mission is to build a fair, credible, responsive, dynamic, and efficient securities market. This is totally aligned to meet the objective of protection of investors by ensuring fair, efficient, transparent markets and reducing systemic risks. Building a credible market for participants and investors depends on sound regulatory and institutional infrastructures. Some tangible efforts have been made in the past and some are in the pipeline and still some reforms have been envisioned for the future. This article aims to highlight on the efforts and the challenges ahead for the market, especially from the perspective of the regulator.

Development Scenario

The Nepalese securities market received an appropriate regulatory structure in 1994 with SEBON as the regulator and Nepal Stock Exchange (NEPSE) as the only stock exchange in the country. The market has undergone some distinct up-down cycles and different phases of market operations and regulatory developments were realized in the country, which are listed as follows: • Open outcry system in stock trading was replaced with the electronic trading system in August 2007. This helped to bring more efficiency and transparency in the trading of securities. • Some 23 small-sized brokers are in the order-matching business to cater the orders of potentially 1.2 million retail investors. • There has also been interest from the private sector to open a stock exchange to compete with the existing stock exchange, Nepal Stock Exchange (NEPSE), owned and managed by the government. SEBON has vowed for a more competitive and professionalized stock exchange while keeping the option open for required reform and transformation of the existing stock exchange. • The IPO market is the most popular component of the securities market where individual investors make an entry into the market. Nearly Rs 15 billion worth (IC 1.0 = NC 1.60) has been mobilized through 63 issues in the fiscal year 2008-09 alone. The merchant banking business, inclusive of new Issue Management, Underwriting, Securities Transfer Registrar and Portfolio Management services, has been licensed to 16 companies, out of which 10 companies are from the finance and banking sector. Under the new regulation, the merchant banking activities of banks and financial institutions are required to be conducted through their subsidiaries within a period of six months.



•

•

•

•

•

The liquidity of securities has been hampered by lengthy and risky manual document and transfer system. It has now been planned to be replaced by an electronic record and transfer system under a full-fledged central depository system (CDS). The Government of Nepal is supported by the Government of India to establish and operate CDS. SEBON has already drafted the required depository law and regulation. NEPSE in association with a group of banking and financial companies has recently initiated to establish the depository company for which CDSL, India, is providing consultancy services. There have been only two collective investment funds traded publicly. They have limited regulatory back-up and their impact in the stock market is small. Collective investment vehicles are needed to realize strong institutional presence for broadening and deepening the financial market. Taking benefit from the open trading environment, some commodity trading exchanges, though unregulated, have started functioning. SEBON is examining its capacity to be in the forefront of regulation of the commodity market and advising the government on the modality of commodity exchanges. SEBON is building its capacity as a well-established regulator. There is definitely a big list of reform needs, which shall be implemented in a phased manner. It has now established rules for the licensing of different categories of businesspersons, stock exchanges, etc. SEBON has identified other rules (regulation, guidelines, and manuals) to establish effective regulation. Obviously these rules are expected to be benchmarked to the international standards appropriate to the domestic market. The capacity building of SEBON is being pursued by establishing a data management and retrieval system with the World Bank’s cooperation. As an evolving regulatory system, the manpower of SEBON is inadequate to regulate the 204 entities, including stock exchange (1), brokers (23), merchant bankers (16), listed companies (163), and many more in the pipeline. SEBON is strengthening manpower through trainings and has started hunting talents from the market and recruiting them in earnest. Besides, it has recently started training and educational programmes targeted at the intermediaries, investors, and exchange staff, which in course of time is envisaged to be developed either as an independent training institute or as a subsidiary institute of SEBON. With a view to joining the international mainstream of securities regulations and facilitating cross-border capital flows, SEBON has already joined the South Asian Securities Regulator Forum, may join IOSCO in the near future, and also enter into an understanding with other regulators, potentially having their regulated entities

showing interest of entering into the domestic market. At this point of time, SEBON has been prioritizing to facilitate the entry of mutual fund companies from private sector, credit rating agencies, central depository and stock exchange companies that have shown interest to establish joint venture or provide technical collaboration or both.

Envisioned Programmes and Challenges Ahead

In the Nepalese financial system, especially in the securities market, companies in the banking and financial sector have predominance. The capital market is to play a critical role for the development of infrastructure, hydro, hotel and tourism sectors to take advantage of comparative and competitive strengths and opportunities. SEBON has envisioned and prioritized the following steps to bring new instruments and deepen the market: • Build the capacity of SEBON to establish it as a credible and trusted regulator with sufficient autonomy, rule making, supervision, and enforcement capability. • Complete the initiative to establish Central Depository for clearing and settlement of securities transactions in electronic form through ‘dematerialization’, without involving any physical certificate. • Encourage to establish Credit Rating Agency for the rating of corporate debt instruments, funds, institutions, and corporate governance. • Establish and promote appropriately regulated dynamic fund management companies. • Take the securities market outside Kathmandu to increase both the coverage of market and access of retail investors to the market. • Establish regulated framework for commodities and foreign exchange brokers. • Encourage to develop the stock broker company as full-fledged security dealer and permit the sub-brokers to enter brokering business. • Join the International Organization for Securities Commission and enter into bilateral understanding with the countries from South Asia to share information and establish regulatory cooperation to facilitate investment flows and intermediary services. • Formulate a Master Plan for the overall development of capital market in the country and implement it through short-term rolling basis. In conclusion, realizing the fact that keeping pace with global and regional technological changes is imperative, SEBON is making every effort to strengthen the regulatory aspects of the Nepalese capital market.

NEPAL

Nepal Strives for Inclusive Growth

Dr Binod Atreya Chief Executive Officer Nepal Bank Ltd

Dr Binod Atreya is a Director of Nepal Rastra Bank. He is on deputation to Nepal Bank Limited. Earlier, he was on deputation to Ministry of Finance as Expert for Budget and Economic Survey preparation. Dr Atreya is responsible for regulatory and supervisory functions of micro-finance institutions licensed under the central bank in Nepal. He had a stint as lecturer in Melbourne College of Technology, Melbourne, Australia. Widely travelled, Dr Atreya attended various seminars and training programmes held in various business centres of the world. Dr Atreya has over 35 published articles and research papers to his credit. He holds masters degrees in Public Administration and Business Administration. He received doctorate from Victoria University of Technology, Melbourne, Australia, for his thesis on Public Management Reform.

While policy statement of the government has focused on poverty reduction and inclusive growth in the country, various problems are creating obstacles for the smooth operations of the industrial sector. There is a need to enhance accountability, responsibility, commitment, and capacity building from all involved stakeholders...

Introduction

Nepal is one of the least developed countries in the world with a per-capita annual income of $468. Population is estimated to be about 28 million as of 2009 with an annual growth rate of 2.5 percent. While the neighboring countries, India and China, had registered a growth of 7.3 percent and nine percent respectively in 2008, Nepal’s performance seems dismal as the growth is expected to be around three percent in FY10. Nepal registered 4.9 percent growth during 1991-2000 but could not sustain it. The growth rate between 2001 and 2006 remained at 2.9 percent. Economic growth rates in FY2007 and FY2008 remained at 3.2 percent and 4.7 percent respectively. The preliminary data for the first three months of FY10 depicts that the economy of the country is further deteriorating. Export has declined by 16.8 percent against an increase of 25 percent in the first quarter of the previous year. Trade deficit increased by 48 percent. Inflation remained at 9.3 percent. Remittance increased by 11 percent (first quarter) compared to a 67.3 percent growth in the same period the previous year. Foreign exchange reserve declined by 11 percent compared to the same period a year ago. Political instability, electric power shortage in the industrial sector, and currently observed liquidity crisis added problems to the economy. Inclusive growth has been an important agenda lately in the development process of the country. Development planning process, which started in 1956, initially focused on sectoral development. While policy statement of the government has focused on poverty reduction and inclusive growth in the country, various problems are creating obstacles for the smooth operations of the industrial sector. There is a need to enhance accountability, responsibility, commitment, and capacity building from all involved stakeholders. The open and liberal economic policies adopted by the government during the 1990s accelerated the development process in the country. Poverty, which was 42 percent in 1995-96, declined to 31 percent in 2003-04. This reduction in poverty level was due to increased inflow of remittances, migration to urban centres, infrastructure development in the rural region, and increase in labour wage rates, among others. The Banking sector was liberalized in mid-1980s. However, it was felt that the benefits of development could not reach to the rural households and, as a result, inequality was deep-rooted and widened.

Financial System in Nepal

The establishment of Nepal Bank Limited (NBL) in 1937 was the beginning of banking sector development in Nepal. Nepal Rastra Bank (NRB), the central bank of the country, was established in April 1956. The development of the financial sector accelerated when



the government adopted the liberalization policy in 1984. Commercial banks, which were two in number in 1984 increased to 10 in 1994 and to 26 in 2010 (March). By the end of 2009, the financial sector included 26 commercial banks, 75 development banks, 78 finance companies, 18 micro-credit development banks, 45 non-governmental organizations authorized to do limited banking activities, and 16 cooperative societies, among others. Despite the growth in the number of financial institutions, contribution to GDP of the country by financial intermediation stands about 3.3 percent (Economic Survey 2008-09), a decrease from a growth of 13.8 percent in the previous year. Capital fund, which remained negative until the year 2006, has become positive to the figure of Rs 52,681.8 million by mid-July 2009. Total deposits of the financial system reached Rs 674,584.3 million in mid-July 2009. Loans and advances was Rs 511,752.8 million. Total asset of the banks and financial institutions was Rs 988,878.8 million.

Financial Sector Growth 80 70 60 50 40 30 20 10 0

1984

1994

2009

Development Banks

Finance Companies

Co-Operative Soc.

NGOs

Micro Credit Dev. Banks

Capital Fund Deposits Investment Loans and Advances Total Assets/ Liabilities

Inclusive Growth: Institutional Arrangements and Policies

The government and the central bank are responsible for making the institutional arrangements that provide financial opportunities to the general public for the economic growth in the country. With a view to increase the access of banking services to the rural poor, governmentowned banks were asked to expand their branches to meet the target of one branch for 30,000 people, endorsed by the 7th Five Year Plan. Nepal Bank Limited (NBL) and Rastriya Banijya Bank (RBB) expanded their branch network, both in urban and rural areas. Later on, this policy measure was withdrawn. During the conflict period, many bank branches were closed or consolidated with nearby branches. Though these two banks are currently expanding their branch network, their outreach has declined compared to 1990s. The branch network of commercial banks has increased substantially, reaching a total of 752 branches as of midJuly 2009.

Support through Micro-Credit Institutions

Commercial Banks

Performance of the Financial Sector (Rs million) Heads 2005 2006 2007 Mid July Mid July Mid July

with the banks. The financial sector was contributing substantially to the pace of national economic development. However, the problem in the financial system appeared from the beginning of FY10. It was understood that there will be no impacts of the global financial crisis in Nepal. But decline in the growth rate of remittances, excessive import compared to exports resulting in a BOP deficit, decrease in the deposit growth rate in the financial system, the liquidity crisis caused by excessive lending, and the resultant execution of strong measures from the regulatory authority have shown the financial system at risks.

2008 Mid July

2009 Mid July

(9,088.10) (7,444.57) 6901.7 284,115.2 327,995.20 391152.6 66,499.10 88,959.57 101888.2 209,054.00 230,509.00 291605.8

25778.0 508905.7 120335.6 391537.7

52681.8 674548.3 141347.3 511752.8

Growth % From 2008 to 2009 104 32.5 17.4 30.7

474,326.00 516,129.30 582477.3

706324.0

988878.8

40

Source: Banking and Financial statistics. No.53, Nepal Rastra Bank

By mid-July 2009, the financial indicators of the banks and financial system were in order and did not show serious problems. Deposit credit ratio of commercial banks stands at 70 percent by mid-July 2009. Deposits and credit were increasing. There was no liquidity problem

Prior to 1950s, informal sector dominated the micro-credit activities in Nepal. In 1956, USAID funded cooperatives were established in Chitwan district to mark the organized micro-credit activities. Priority sector credit programme was launched in 1973. Subsequently, NRB made a mandatory requirement of lending of 5 percent of total deposit to the deprived sector. Agricultural Development Bank, established in 1968, initiated a Small Farmer Development Project in 1975, which was later converted into Small Farmer Development Bank in 2001. A gender-focused programme ‘Production Credit for Rural Women’ (PCRW) was launched in 1982, enabling women in groups to avail formal credit facilities. Other women-focused programmes launched by the Government of Nepal were Micro-Credit Project for Women (MCPW) and Women Awareness and Income Generation Programme (WAIG). With a view to provide wholesale financing to the Cooperatives and NGOs, Rural Self Reliance Fund was established in 1991 and Rural Microfinance Development Centre in 1998. The Grameen Bank model pioneered by Professor Mohammad Yunus in 1976 in Bangladesh was replicated in Nepal with the establishment of five rural development banks in various regions. The government also introduced a series of projects with a view to help the rural poor.

NEPAL

Currently, micro-finance activities in Nepal are promoted in various forms. They include public and private sector modalities, wholesale banking, project-based and communitybased models. The Nepal Rastra Bank regulates commercial banks, development banks, finance companies, micro-finance development banks (MFDBs), saving and credit cooperative societies (SACCOs), and financial intermediary nongovernmental organizations (FINGOs). Available data suggest that micro-credit development banks loan portfolio reached Rs 5608.0 million in mid-January 2009 from Rs 5109.5 million in mid-July 2008.

Issues and Challenges

Inclusive growth in Nepal is constrained for various reasons. Despite the fact that the policy measures acknowledge the importance of inclusiveness, in reality the government plans and programmes have not reached to the poor people. The Asian Development Bank (ADB) clearly noted that the major constraints to inclusive growth in Nepal are due to (a) lack of productive employment opportunities; (b) unequal access to opportunities; (c) weak human capabilities; (d) uneven playing field; and (e) inadequate social safety nets. Furthermore, economic growth is constrained due to political instability, limited and low quality infrastructure, labour market rigidities and weak industrial relations. The Asian Development Bank suggested to strengthen the governance and its components and to promote social and economic inclusion. The physical feature of the country poses a great challenge for inclusive growth. A study conducted by the World Bank has shown that Nepal is weak and needs improvement in availing finance to the general public. Nepal is slightly ahead of Bangladesh in terms of ATMs penetration. In all other indicators, Nepal’s position is weak, when compared with other South Asian countries.

Micro-credit is the main area for rural financing in Nepal. Although there are wholesale and retail MFIs in Nepal, their activities are constrained by availability of fund, high cost of fund, lack of integrated efforts for creating demand for credit, lack of information to the households on the availability of credit, lack of integrated approach as to regulatory and supervisory mechanism for micro-credit programmes, and unfair competitions among the MFIs in areas of their concentration. As a result of Nepal’s membership to World Trade Organization (WTO), Nepalese financial sector is open to the international markets. The regulatory authority has already issued necessary directives, including capital requirement and areas of operations, for international banks to open their branches in Nepal. Nepalese banks would also find option to operate abroad. This calls the need for quality product and services to remain competitive in the international market. The challenge for financial institutions is to get ready to benefit from the opportunities brought by the liberalization of the financial market.

Conclusion

Looking at the geo-political and cultural situations of the country, development process focused on inclusiveness is necessary in Nepal. Since Nepal is an agro-based country, agriculture and non-agricultural sectors contribute about 32 percent and 68 percent respectively to GDP, focus should be given to explore the agricultural growth of the country. The role of the banking sector role is important. The incidence of poverty can be reduced provided the access of finance is reached to the poor households along with programmes of employment and economic activities.

Indicators

Bangladesh

India

Nepal

Pakistan

Sri Lanka

Benchmark

Demographic Branch penetration (branches per 100,000) Demographic ATM penetration (ATMs per 100,000) Loan accounts per 1000 people Geographic branch penetration (branches per 1000 km) Deposit accounts per 1000 people Geographic penetration (ATMs per 1000 km)

4.64 0.20 60.45 43.41 237.32 1.84

6.33 1.63 71.42 22.99 432.11 5.93

1. 67 0.24 11.30 2.87 113.58 0.41

4.82 0.67 30.57 9.22 173.15 1.29

7.20 4.50 344.17 14.64 1066.24 9.15

9-28 39-158 248-776 1-57 976-2418 3-241

Source: Getting Finance in South Asia, 2009, The World Bank (The benchmark is developed from the developed countries.)


NEPAL

Dividend Policy of Nepalese Enterprises

Nabaraj Adhikari Deputy Director Securities Board of Nepal

Nabraj Adhikari is Deputy Director of the Planning and Development department at SEBON. He is also Project Manager of the Securities Data Management System project. Mr Adhikari has contributed a lot to the SDMS project.

The effect of an enterprise’s dividend policy on the current price of its shares is a matter of considerable importance, not only to the corporate officials who must set the policy, but to investors for planning portfolios and to economists seeking to understand and appraise the functioning of the capital markets...

Background

Dividend policy determines the division of earnings between payments to shareholders and reinvestment in the enterprises. It is at the very core of corporate finance, which brings to the fore the conflict of interests between the management and the shareholders, and also that of one group of shareholders with those of another. The dividend policy has remained a contentious issue ever since the early stage of corporate development, making it one of the unresolved puzzles in corporate finance theory. Dividends are still an unresolved mystery for financial economists, eluding any single theory. Miller (1986) argued that providing a rational explanation for the widely practiced policy of paying dividends is among the central tasks of modern corporate finance theory. Enterprises attach more importance to stable dividends than to performance-linked dividends (Mizuno, 2007). The stability of dividends is one of the considerate aspects of dividend policy to the enterprises. Miller and Modigliani (MM, 1961) showed that when investors are capable of creating any payout pattern they want by selling and purchasing shares, the expected return that is required to induce them to hold the shares will be invariant to the way in which enterprises ‘package’ gross-dividend payments and new issues of stock. When an enterprise issues new equity to finance its increased dividend, dividend policy is irrelevant if the new equity is sold at a fair price. Because efficient markets ensure that all assets are fairly priced, the dividend irrelevance arguments require that markets be efficient. Although, under the MM proposition, there are no specific reasons for enterprises to follow any systematic dividend policy, there are also no penalties if they choose to do so. To the extent that imperfections exist, they may support the contrary position, that is, dividends are relevant (Gordon, Lintner and Walter). Lintner (1962) argued that generalized uncertainty is itself sufficient to ensure that shareholders will not be indifferent to whether cash dividends are increased (or reduced) by substituting new equity issues for retained earnings to finance given capital budgets. Gordon (1963) argued that the required rate of return used by investors to discount dividends expected in future increases with time. As a result, investors would value current dividends over capital gains. Dividend policy does affect shareholders’ welfare in the presence of transaction costs (Huberman, 1990). The existence of transaction costs and any aversion to the inconvenience of selling shares tend to favour current dividends over capital gains. In a world of significant agency problems between corporate insiders and outsiders, dividends can play a useful role. Jensen (1986) stated that managers, motivated by compensation and human capital considerations, have incentives to over-invest free cash flows even in the absence of profitable growth opportunities. By paying dividends, insiders return corporate earnings to investors and hence are no longer capable of using



these earnings to benefit themselves (Porta et al., 2000). Dividend payout policy in such a case becomes a vehicle for monitoring the managers’ potential to misuse excess funds. By announcing dividends, the management exposes the internal governance of the enterprises to the outsiders, leading to effective and efficient monitoring. There is a strong tendency for enterprises to maintain stable dividends and not adjust dividends in relation to the financial need for investment (Serita and Hanaeda, 2007). Further, enterprises attach more importance to stable dividends than to performance-linked dividends (Mizuno, 2007). Most respondents believe that dividend policy affects enterprise value and they are concerned about continuity of dividends when setting dividend payments (Baker and Powell, 2000). Surveys of financial executives suggest that managers only increase dividends when strong earnings are sustainable in future (Wann D. and Long, 2009). Stability of dividends is one of the considerate aspects of dividend policy to the enterprises. The knowledge of an enterprise’s dividend policy can contribute significantly in explaining the return received on the enterprise’s securities (Bar-Yosef and Kolodny, 1976). The effect of an enterprise’s dividend policy on the current price of its shares is a matter of considerable importance, not only to the corporate officials who must set the policy, but to investors for planning portfolios and to economists seeking to understand and appraise the functioning of the capital markets (MM, 1961). One of the most popular models for stock valuation relies on the assumption that the enterprise will pay dividends until eternity. Viewed in the aforementioned theoretical perspective of dividend relevance and irrelevance as well as practical perspective of paying dividends, the study on dividend policy of Nepalese enterprises devoted to offer further evidence in the area of corporate finance theory and capital market may be of considerable importance.

Statement of the Problem

Dividend policy is both pervasive and perplexing. It is pervasive that enterprises have been paying regular cash dividends since the dawn of the modern limited liability enterprise, and publicly traded enterprises in all market economies have been paying out large fractions of their earnings ever since. Dividend policy is perplexing because it is not obvious why investors should demand cash dividends. MM (1961) argued that the value of the enterprise depends on the enterprise’s earnings, which depend on its investment policy. According to them, the investor is indifferent to either dividend payment or capital gains under perfect market conditions. Gordon (1989) objected to the MM argument saying that they would have been correct if the sales of shares were a perfect substitute for retained earnings in financing investment, and if the repurchase of shares were a perfect substitute for dividends in making

distributions to shareholders. Both of these conditions would be true under the perfect capital market assumptions, i.e., there are no taxes, no flotation costs, no transaction costs or other market imperfections. The present issue is whether the investors are indifferent between dividend payments and capital gains in Nepal. Major changes in earnings out of line with existing dividend rates were the most important determinants of an enterprise’s dividend decisions (Lintner, 1956). Empirical evidence suggests that profitability, investment opportunities, and size are the factors determining dividends (Fama and French, 2001). Dhameja (1972) contended that lagged dividend is directly associated with current year dividend and fluctuations in dividend determination are influenced by current year earnings. The survey of the views of managers by Bhat and Pandey (1995) in India revealed that current earnings, pattern of past dividends, expected future earnings, equity base and liquidity are the five top determinants of dividend policy. Though there are these findings on the determinants of dividend policy in developed countries and in India, they are not yet clearly known in Nepal. Graham and Kumar (2006) documented that older and low income investors purchase stocks following dividend announcements. Financial executives are hesitant to make big changes to payout policy because such changes might alter an enterprise’s investor base and adversely affect its stock price (Brav et al., 2005). Baker and Wurgler (2004) developed a hypothesis in which the decision to pay dividends is driven by investor demand. Regarding dividend policy of Nepalese enterprises, Shrestha (1981) argued that corporate management has never considered dividend payment as an entrusted obligation to shareholders. Similarly, Manandhar (2002), based on the results of empirical and survey studies, stated that corporate enterprises in Nepal do not follow a liberal dividend policy. Based on the empirical findings, Pradhan (2003) argued that dividend payment is more important as compared to retained earnings in Nepal. The positive relationship has been documented between dividend payments and the market price per share in Nepal (Rai, 2008). Taken together, the arguments and evidences on dividend policy in Nepal are in support of the positive effect of dividends on the value of the enterprise. Though the aforementioned studies are good in their own right, with the exception of a few issues, many of the issues on dividend policy of Nepalese enterprises still remain unresolved. The problem basically emanates from a few empirical studies and surveys on dividend policy with small sample size and limited study period. The specific issues to be investigated in this study, therefore, include the following: •

What are the major determinants of dividend policy of Nepalese enterprises?

NEPAL

• • • • • • • • •

Do the major determinants of dividend policy of Nepalese enterprises differ with the determinants of dividend policy of developed countries enterprises? What are the legal provisions relating to dividend policy of Nepalese enterprises? Is there any net tendency of investors to gravitate to any particular payout policy? What is the ex-dividend date effect in Nepal? Is there any specific behaviour of stock price near the ex-dividend date? Does dividend announcement have any influence on the value of Nepalese enterprises? Is there any group-specific influence of dividend announcement? Is the dividend policy a significant factor in determining the market value of the enterprise in Nepal? Should a Nepalese enterprise adopt a high (or low) payout policy? What was the trend in stock dividend payments over the period? Is there any specific trend evolving from stock dividend payments over time in Nepal? What is the effect of stock dividend payments on stock price? Is there any information content of stock dividend announcement in Nepal? What are the views of managers on dividend policy in Nepal? What are the views of stockbrokers on dividend policy in Nepal?

Objectives of the Study

The specific objectives of the study were as follows: • Examine the determinants of dividend policy and address the issue on the group-specific importance of determinants of dividend policy in Nepal. • Analyse dividend-clientele effect, ex-dividend date effect and stock price behaviour near the ex-dividend date in Nepal. • Investigate dividend announcement effect on the value of the enterprise in Nepal thereby analyse the group specific influence of dividend announcement too. • Determine the effect of dividends on the value of the enterprise including the group-specific effect of dividends on the value of the enterprise in Nepal. • Examine the trend in stock dividend payments, and analyse the effect of stock dividends on stock price, information content of stock dividend announcement, dividend payout patterns, and dividend policy behaviour in Nepal. • Analyse the views of managers, investors and stockbrokers on dividend policy in Nepal.

Propositions

In order to achieve the aforementioned objectives, the following propositions were developed: • Dividend policy of an enterprise tends to depend on net profits, growth rate of revenue, lagged dividends, risk, investment opportunity, and number of common stockholders. • Stock with high dividend yields would be preferred by investors with low income, elderly investors and investors with low tax brackets. • The pre-dividend anticipatory price rise tends to be more

• •

concentrated in a week before the ex-dividend date. There is a positive return following the announcement of cash dividends and the positive reaction of the market to the dividend announcement is not due to other events. There is a positive effect of dividends on the value of the enterprise and the effect does not vary across different groups of enterprises.

Methodology for Study

The methodology employed for the study comprises research design, nature and sources of data, study period, selection of enterprises, methods of analysis, and limitations of the study. The multiple approaches to data collection and analysis were used in this study. The information relating to dividend policy of selected Nepalese enterprises was proposed for study. This study was based on both primary and secondary data. The secondary data used were of daily and annual in nature. The secondary data were primarily collected from the various published sources, viz., economic surveys, annual reports of Securities Board of Nepal (SEBON), annual reports of Nepal Stock Exchange Ltd. (NEPSE), company profiles, annual reports of Nepal Rastra Bank, annual reports of listed enterprises, and minutes of the annual general meetings of listed enterprises. The secondary data were also gleaned from different websites. The primary data required for this study were collected through structured questionnaire surveys of managers, investors and stockbrokers. The study period chosen for this study in each sample ranged from a minimum of three years to a maximum of 12 years from the year 1995 to 2006. There were a total of 135 listed enterprises in Nepal as of mid-July 2006. All of them did not provide scope for the study as this study relates to regular dividend paying enterprises. Considering the study period of 1995 to 2006, there were 57 listed enterprises paying dividends for three years or more in Nepal. The effect of dividends on the value of the enterprise was determined by using pooled cross-section data for various classifications of sample enterprises. As such, the effect of dividends on the value of enterprise was determined using two samples, namely overall sample and group-specific sample. Based on the nature of the group companies and number of selected listed companies, the overall sample was classified into four groups, namely banking group, finance companies group, insurance companies group, and manufacturing and processing, trading, hotels and other companies group. The overall analysis and group-specific analysis of the effect of dividends on the value of the enterprise were accomplished by computing correlations and regression equations. In order to analyse the effect of stock dividends on stock price, the base date was set at six months prior to the ex-dividend date. The first comparison was made on the ex-dividend date and the final comparison was made six months after the ex-dividend date. The yearly declaration of cash dividends and net profits corresponding to gross domestic product were considered to


analyse the general dividend patterns in the economy. The earnings and dividend patterns of a major enterprise were analysed to examine dividend policy behaviour. Legal provisions relating to the dividend policy of the enterprises were analysed by reviewing relevant corporate laws of Nepal. To survey the views of managers, investors, and stockbrokers on dividend policy, three sets of questionnaires were developed based on a careful review of existing theoretical and empirical works on dividend decisions and distributed to a group of prominent academics and practitioners for pre-test. The survey questionnaires were revised by incorporating their suggestions, resulting in minor adjustments to the original documents. In the context of Nepal, data scarcity is acute. Updated and complete data are limited due to the manual securities data management system prevailing in the country. There is no automated central securities data bank and this makes it difficult to conduct any research in Nepal. As the results on the analysis of dividend-clientele effect in this study were based on the regression analysis using variables obtained through survey request for dividend yields, income classes, age and tax brackets due to absence of data relating to these variables from secondary sources, which may contain measurement errors. Therefore, caution should be exercised in generalizing the findings relating to dividendclientele effect. A major statistical problem in this study was obtaining a measure of stock price behaviour on ex-dividend dates. In case of non-availability of closing price on ex-dividend day, the subsequent day (as subsequent as one month) price was considered as ex-dividend day price. Similarly, in case of non-availability of closing price on previous day of ex-dividend day, the closing price back to previous day (as back as one month) was considered. This problem mainly emanated from the infrequent trading of some stocks. Hence, the results of study might have affected due to not employing exact date data as required. Therefore, the results of this study are limited to the sample. No inference will be made about the entire population of enterprises making dividend announcement, paying stock dividends and dividend policy behaviour of all enterprises in Nepal. At the time of conducting this study, secondary data were available only up to 2006 though these should have been available up to 2007. It was due to the fact that most of the selected listed enterprises had not prepared and audited their financial statements in time. Hence, the year 2007 could not be considered in the study. Finally, the analysis of responses of investors highly concentrated on the responses collected from the investors of Kathmandu valley, only very few responses of investors outside of the Kathmandu valley could be collected. Therefore, a caution is needed while interpreting and generalising the results of the survey of investors of this study.

Major Findings of the Study

Based on the analysis of secondary data and survey responses, the major findings of the study are summarised as under: 1.

The test of the effect of dividends on value of the enterprise revealed that there is a positive effect of dividends on the value of the enterprise of overall group as well as specific groups.

2.

The results of the examination of determinants of dividend policy revealed that net profits and lagged dividends have a positive effect on dividend policy.

3.

The stocks with higher dividends payout have higher net profits, higher lagged dividends, and lower growth rate of revenue. The net profits, lagged dividends, and growth rate of revenue of stocks paying higher dividends are more variable as compared to stocks paying lower dividends.

4.

The group-specific analysis on the determinants of dividend policy revealed that net profit is the major determinant of dividend policy for banking group; insurance companies group; and manufacturing and processing, trading, hotels, and other companies group. Net profit, lagged dividends and number of common stockholders are the major determinants of dividend policy for finance companies group.

5.

The analysis of descriptive statistics for sub-samples revealed that the banks pay more dividends as compared to the finance, insurance, manufacturing and processing, trading, hotels, and other companies. The analysis also revealed that the risk is higher for finance companies than for the banks, insurance, manufacturing and processing, trading, hotels, and other companies.

6.

The analysis of legal provisions revealed that the Nepalese enterprises can declare and pay dividends to the shareholders within a framework provided by Companies Act, 2006, and if the enterprises are of banks and finance companies, they can pay dividends to the shareholders within a framework provided by Bank and Financial Institutions Act, 2006 and Unified Directives, 2005 issued by Nepal Rastra Bank.

7.

There is non-existence of dividend-clientele effect in Nepal since the assessment of dividend-clientele effect revealed the results inconsistent to expected sign and with statistically insignificant coefficient. However, this finding based on econometrics analysis is inconsistent with the survey results of this study.

8.

The analysis of ex-date effect on the stock price of listed enterprises indicated that there is a probable price drop-off about 68.5 percent of dividends in Nepal. Similarly, analysis of behaviour of stock price near the ex-dividend date provides evidence that the pre-dividend anticipatory price rise tends to be more concentrated in a week before the ex-dividend date.

9.

As regards dividend announcement effect, the study revealed that dividend announcement increases the value of enterprise.

10. There is a possibility of insider trading prior to the dividend announcement as the results of the analysis of dividend announcement effect show that the excess returns are more or less similar in all the days during 9 days period before the dividend announcements without being concentrated on dividend announcement day.

NEPAL

11. The observation of trend in stock dividend payments during 1995 to 2006 revealed that Nepalese listed enterprises are issuing stock dividends regularly and the rate of stock dividend payments is at increasing order. 12. The analysis of effect of stock dividend payments on stock price revealed that the real price gain of enterprises paying stock dividends is 31 percent on ex-dividend date and six month after the ex-dividend date over the price of six months preceding the ex-dividend date. 13. The test of the information content of stock dividend announcement revealed that stock dividend announcement does not produce positive unexpected returns, which implies that there is no information content of stock dividend announcement. The implication of this finding is that there is leakage of information of probable stock dividends before its actual announcement in Nepal, given the initial stage of capital market development. 14. The analysis of dividend patterns and growth in Nepalese economy during the study period 1995 to 2006 revealed that dividend follow economic trend in positive direction. This finding implies that favourable economic performance of the country leads to favourable performance of the corporate sector. 15. The analysis of dividend policy behaviour of a prominent Nepalese enterprise having a track record of regular dividend payments during the study period 1995 to 2006 revealed that dividends are increased only when an increase in earnings appears clearly sustainable. 16. The analysis of the responses of managers revealed that dividend decisions are very important and the managers from banking and non-banking groups had similar opinions on the issues of dividend policy. 17. Dividend is not a residual decision of Nepalese enterprises as opined by the majority of responding managers, investors and stockbrokers. The information disclosure practice of the listed enterprises is poor as responded by majority of responding investors and stockbrokers, and the transaction cost in buying and selling securities is high in Nepalese capital market as responded by majority of responding investors. 18. The majority of responding managers, investors, and stockbrokers stated that major motive of stock dividend payments of Nepalese enterprises is to increase equity capital base of the enterprise. 19. The majority of the responding investors stated that on an average 11 to 20 percent rate of return is attainable on a regular basis from investments in common stocks, stock dividend announcement is the most preferred corporate event in Nepal, and dividend declaration provides more accurate information of the value of the enterprise.

20. Reasons for dividend policy changes should be adequately disclosed to investors as opined by the majority of responding managers and stockbrokers.

Conclusion

The major conclusions of this study are that dividends affect the value of the enterprise, the net profits and lagged dividends are the major determinants of dividend policy, and there is no group specific importance of the determinants of dividend policy in Nepal. Importantly, the other conclusions of the study are the stock price drop-off is less than the amount of dividends on ex-date, the pre-dividend anticipatory price rise tends to be more concentrated in a week before the ex-dividend date, and dividend announcement increases the value of the enterprise in Nepal. The study also led to conclude that dividends follow economic trend in positive direction, information disclosure practice of the listed enterprises is poor, the most important motive of paying stock dividends is to increase the equity capital base of the enterprise, and stock dividend announcement is the most preferred corporate event in Nepal.

Recommendations

Based on the major findings of the study, and theoretical and empirical works reviewed, research methodology adopted and data employed in the study; the study deserves to provide some recommendations. 1.

Since the market value of the enterprise depends on dividends per share, i.e., dividends have positive effect on the value of the enterprise, an enterprise should adopt a high payout policy, other things remaining the same, to attain a high price for its stock.

2.

Since the investigation on dividend announcement effect revealed that dividends have information effect and also once dividends are initiated, shareholders apparently anticipate a periodic signal by enterprise and enterprise is forced to submit to a periodic review, the enterprises should initiate or increase dividend only when they are sure of maintaining it in future.

3.

As the study revealed the existence of dividend announcement effect that increases the value of the enterprise, the enterprises should use dividend announcement as a method of indicating the enterprise’s earning power, liquidity and reducing risk.

4.

As the study revealed that dividend announcement, and cash dividend and stock dividend payments affect the value of enterprise, investors should analyse among others, dividend policy of the enterprises while making investment in the stocks.

5.

As the study on ex-date effect on the stock price indicated that there is a price drop-off of less than the dividends


per share, investors should buy stocks before ex-date and sell after ex-date to maximise returns on stock investments other thing remaining the same.

shareholders, so the enterprises of this group should optimally mobilise shareholders funds and provide return in the form of dividends.

6.

As dividend policy affects the growth of the enterprise and demands real cash rather than accounting profit figures, which investors distrust, the stockbrokers should advise their clients based on the analysis of various aspects of dividend policy.

12. Since the majority of responding managers and stockbrokers emphasized that the dividend policy changes should be adequately disclosed to investors, enterprises are recommended to communicate dividend policy to the investors.

7.

Investors should take stock investments as profitable investment as majority of responding investors stated that a satisfactory rate of return is attainable on a regular basis from the investments in common stocks.

13. It is recommended that the information disclosure practices of the enterprises should be improved in order to increase investors’ confidence.

8.

Investors should consider dividend declaration and stock dividend announcement as the important events providing precise information and signalling as responded by majority of responding investors and also in view of poor information disclosure practices of the listed enterprises in Nepal.

9.

The enterprises should improve information disclosure practices in view of majority of the responding investors and stockbrokers responses that the information disclosure practices of the enterprises are poor and also it is the responsibility of the enterprises to comply disclosure-related regulatory provisions.

10. The enterprises are recommended to follow a stable dividend policy, as far as possible, as this would enable it to retain the confidence of shareholders by fulfilling the desire for current income, improve the level of share prices and facilitate in fulfilling funds requirements from the capital market as and when required, decrease marketability risk as well as financial risk, greater participation of institutional investors, and so on. 11. As opined by the majority of stockbrokers and also observed in the market, the number of enterprises from manufacturing and processing group is very low that pays dividends to the

14. As there are leakages of information related to probable dividends and stock dividends before their actual announcements, the regulatory bodies should investigate insider trading and take punitive actions based on the findings. 15. As this study is limited because of the insufficiency of required data, there should have an initiative from the private sector or the government sector to develop a securities data management system. 16. As responded by the majority of stockbrokers the dynamism of capital market will be increased with the increasing number of enterprises paying stable dividends as they are traded more actively, the Government of Nepal is recommended to provide tax rebate to the enterprises paying regular dividends. 17. Since the majority of responding managers of the Nepalese enterprises commented that a large number of investors are not aware of dividend policy, Securities Board of Nepal and Nepal Stock Exchange Limited are recommended to educate the present and potential investors in order to develop and promote the capital market in the country.

PAKISTAN


Exchange Industry

Other Asset Classes

Exchanges


Stock

Number

3

Commodity

Number

1

N/A

Commodity Markets

Capital Markets

Regulator

Name

SECP

Exchanges

Number

1

Names

Gold, Rice

Regulator

Name

Securities & Exchange Commission of Pakistan

Major Commodities Traded

Brokers

Number

200

Banking

Registrars

Number

above 50

Regulator

Name

State Bank of Pakistan

Depositories

Number

1


Number

44

Companies Listed

Number

651

Public Sector

Number

8


$ mn

32098.22

Private Sector

Number

18


%

36.43

Foreign

Number

14


%

49

Specialized Banks

Number

4

Turnover (2009)

$ mn

22060


%

61.31


%

81.92



%

around 20% at year end


%

5


9.29

Prime Lending Rate

%

15.3

Products Offered

Equities, Debt, Stock & Index Futures

Bank Assets to GDP

%

62.8

T+2

Mutual Fund Industry Regulator

Name

SECP

Fund Houses

Number

24

Total AUM

Pakistan Rupee billion

184

Settlement Cycle

T + ….

12.3

PAKISTAN

Pakistan Foresees a Better Future

Muhammad Lukman Chief Executive Officer National Clearing Company of Pakistan

Muhammad Lukman has more than 20 years of diversified managerial experience with national and multinational companies, including Rhone-Poulenc Rorer Limited, Coca Cola Beverages Pakistan, and Central Depository Company of Pakistan Limited, where he was General Manager, Finance and Trusteeship Operations, for seven years. Mr Lukman has also been serving on different committees, including Margin Financing Committee formed by the Securities and Exchange Commission of Pakistan and CFS MK II Committee. He has also represented the Company on different national and international forums. Mr Lukman has attended training and workshops on capital markets, including the training seminar organized by US Securities and Exchange Commission in Washington, DC. He is a Fellow Chartered Accountant, Cost and Management Accountant, and Corporate Secretary by qualification.

An enhanced share of institutional holding will not only improve the corporate governance and earnings but also encourage the saving culture in the economy. The main challenges in the context of Pakistan are the problem of liquidity, small investor, and issuer base.

Pakistan is the 27th largest economy in the world in terms of purchasing power and the 48th largest in absolute dollar terms. Pakistan’s economy is primarily based on agriculture; it is also termed as a semi-industrialized economy. The economy has suffered in the past from decades of geo-political situations, a fast-growing population, mixed levels of foreign investment, and costly, ongoing security measures. However, the World Bank-approved government policies, supported by direct and indirect foreign investments, have renewed access to global markets. This has generated solid macroeconomic recovery in the last decade. Since 2000, substantial macroeconomic reforms have taken place and that have helped the economy. Of these, the most notable is the privatization of the banking sector. “Pakistan was the top reformer in the region and the number 10 reformer globally— making it easier to start a business, reducing the cost to register property, increasing penalties for violating corporate governance rules, and replacing a requirement to license every shipment with two-year duration licences for traders,” the World Bank reported in 2005. GDP growth, spurred by gains in the industrial and service sectors, remained in the 6-8 percent range in 2004-06. However, inflation remains the biggest threat to the economy, jumping to more than 12 percent in 2009; though efforts are on to stabilize foreign exchange reserves. Pakistan emerged as one of the best performers in the wake of the global financial crisis, even as the country waged a costly war against militants. Its domestically-driven economy was least affected and its banking sector boasted surplus liquidity while remaining unharmed. However, an impact was seen in the export sector, which shrank as a result of lower external demand. The World Bank and International Finance Corporation’s flagship report ‘Ease of Doing Business 2010’ ranked Pakistan 85 amongst 181 countries around the globe. Pakistan ranks top in South Asia and is on a higher slot than China, Russia and India, which is at 133. The top five countries are Singapore, New Zealand, the United States, Hong Kong, and the United Kingdom. Over the last few years, the Government of Pakistan has granted numerous incentives to technology companies wishing to do business in Pakistan. A combination of decade-plus tax holidays, zero duties on computer imports, government incentives for venture capital, and a variety of programmes for subsidizing technical education are intended to give impetus to the nascent Information Technology industry. In recent years, this has resulted in an impressive growth in that sector.



Since 2008, Pakistan’s economic outlook has stagnated. Security concerns stemming from the nation’s role in the war on terror have created great instability and led to a decline in FDI by approximately 45 percent. Concurrently, the insurgency has forced massive capital flight from Pakistan to the Middle East. Combined with high global commodity prices, the dual impact has shocked Pakistan’s economy, with gaping trade deficits, high inflation and a crash in the value of the rupee, which has fallen from 60-1 USD to over 80-1 USD in a few months. The EIU estimates that inflation should drop back to single digits in 2010 and that growth should pick up to over 5 percent per annum by 2011. Although it is less than the previous 5-year average of 7 percent, it will overcome the present crisis wherein growth is a mere 3.5 to 4 percent. Pakistan stands fifth in the Muslim world and 20th worldwide in farm output. It is the world’s fifth largest milk producer. A reduction in the fiscal deficit has resulted in less government borrowing in the domestic money market, lower interest rates, and an expansion in private sector lending to businesses and consumers. Pakistan’s banking sector has remained remarkably strong and resilient during the world financial crisis in 2008-09, a feature that has served to attract a substantial amount of FDI in the sector. Pakistan is now the most investment-friendly nation in South Asia. Business regulations have been profoundly overhauled along liberal lines. Most barriers to the flow of capital and international direct investment have been removed. Foreign investors do not face any restrictions on the inflow of capital, and investment of up to 100 percent of equity participation is allowed in most sectors. Unlimited remittance of profits, dividends, service fees or capital is now the rule. Business regulations are now among the most liberal in the region. Pakistan is attracting an increasingly large amount of private equity and was ranked 20th in the world based on the amount of private equity entering the nation. Pakistan has been able to attract a large portion of the global private equity investments because of economic reforms initiated in 2003. With the rapid growth in Pakistan’s economy, foreign investors are taking a keen interest in the corporate sector of Pakistan. In recent years, majority stakes in many corporations have been acquired by multinational groups. The foreign exchange receipts from these sales are helping Pakistan cover the current account deficit. In Pakistan, the commercial banks and development finance institutions (DFIs) are working under the supervision of the State Bank of Pakistan, while the nonbanking finance companies (NBFCs) are functioning under the supervision of the Securities and Exchange Commission of Pakistan (SECP). Being the guardian of money market, the State Bank of Pakistan is responsible to supervise the operation of those institutions that can directly affect the money market operation and performance, while the SECP is responsible for all the companies that offer their securities to the general public. The NBFCs are allowed to offer business in the areas

of leasing, investment advisory services, assets management services (open-ended and close-ended mutual funds), and financing (including housing finance). An Overview of Pakistan’s Economy Indicator 1999 GDP $ 75 billion GDP Purchasing $ 270 billion Power Parity (PPP) GDP per Capita $ 450 Income Revenue collection Rs 305 billion Foreign reserves $ 700 million Exports $ 7.5 billion Karachi Stock $ 5 billion at 700 Exchange (100points Index) Foreign Direct $ 1 billion Investment Development Rs 80 billion programmes

2007 $ 160 billion $ 475.5 billion

2008 $ 168 billion $ 439 billion

2009 $ 185 billion $ 580.6 billion

$ 925

$1085

$1250

Rs 708 billion $ 16.4 billion $ 18.5 billion $ 75 billion at 14,000 points

Rs 990 billion $ 10 billion $ 19.22 billion $ 56 billion at 9,000 points

Rs 1.05 trillion $ 14 billion $ 18.45 billion

$ 8.4 billion

$ 5.19 billion

$ 4.6 billion

Rs 520 billion

Rs 549.7 billion

Rs 880 billion

It has become a common observation that all the above-mentioned institutions compete with each other. The banks provide the services like leasing and the leasing companies provide loan facility through finance lease business. In fact, leasing business implies the operating leasing, which is an ignored area in Pakistan and a negligible part of the total leasing activities. It is important that banks and financial institutions are drivers of the industry; they provide the financing facility to the industry. However, their role should be properly defined and implemented. It was observed that those institutions have been creating unbalanced growth because their businesses are in a few concentrated areas like home financing, car leasing, and consumer financing. The commercial banks should focus on lending to small and medium enterprises (SMEs) for short and medium terms; investment banks should focus on the equity and debt financing for long-term ventures; investment advisory and assets management companies are already working for the investment in the secondary market. The weakest area of the capital market is the Modarba institutions. It is important to note that Modarba is not a type of business; it is a type of company. However, the majority of Modarbas in Pakistan is involved in the leasing, investment and other similar types of business. The role of Modarbas in the economic value addition has always been questionable. They have not been serving in the manufacturing or industrial activities. There is a need to mobilize the Modarbas’ funds for industrial growth by direct investment.

PAKISTAN

In the industrialized countries and the economies of the Far East, institutional investors hold the majority of equities. In Pakistan, 40 percent equity shares are held by the directors and promoters, 35 percent by the small investors and only 25 percent by the institutional investors. There is a need to improve this situation. An enhanced share of institutional holding will not only improve the corporate governance and earnings but also encourage the saving culture in the economy. The main challenges in the context of Pakistan are the problem of liquidity, small investor, and issuer base. On the other side, currently, the Pakistan’s current account deficit has narrowed down by some 69 percent in first seven months of the current fiscal year mainly due to huge remittances and considerable decline in trade deficit. In Pakistan, the traditional mode of financing infrastructure projects through Public Sector Development Programme has resulted in congestions, shortages, and bottlenecks. The experiment with the independent power producer types of arrangements in the private sector has not proved satisfactory from the viewpoint of the consumer. As far as the e-Banking in Pakistan is concerned, it is worthwhile to note that a lot of progress has been made in establishing the platform for electronic banking. With the de-regulation of the telecommunication sector in Pakistan, the opportunities for further value-added services to underpin banking transactions have multiplied manifold. While small and medium banks can

now offer online services to their customers, the large banks have to move more expeditiously so that the e-Banking network can be utilized optimally. Transaction costs will become lower and customer service will improve. A variety of new services has now been offered. The ATM penetration ratio is still quite low and it should be expanded more aggressively. The role of investment banking in Pakistan has remained quite slow so far. The spread of universal banking model in the country has led to a certain degree of ambiguity as far as the market niche in which investment banks can operate. In the recent past, several investment banks have merged into commercial banks. The advent of Basle II regime in a couple of years imposes a sense of urgency on both the regulators as well as the financial industry. In this respect, foreign banks operating in Pakistan have no problem making the transition successfully but there is a chance of having implementation problems and bottlenecks for the domestic banks. In the area of the Islamic banks and branches in the country, an extremely positive development has been seen in recent years. SBP has a highly liberal licensing policy for opening Islamic banks, subsidiaries, or branches. However, SBP has advised all banks that they should have all the ingredients in place before applying for such licences. Despite all odds being faced by Pakistan, the prospects of financial industry in Pakistan are very bright, and Pakistan’s economy has a lot of potential to grow even faster.


PAKISTAN

Corporate Banking

Atif R. Bokhari President & CEO United Bank Limited

Atif R Bokhari is a career banker with extensive experience in domestic and international banking. He started his banking career in 1985 with Bank of America. Mr Bokhari joined Habib Bank Limited in 2000 as Head of Corporate and Investing Banking. Mr Bokhari was appointed as President and CEO of United Bank Limited (UBL) in May 2004. He holds the office of Chairman or Director in several UBL Group companies. He is also a Director of First Women Bank Limited. Mr Bokhari is very actively involved with a private sector programme for the development of education in Karachi. He is the Chairman of the Human Resource Committee of the Institute of Bankers in Pakistan. Mr Bokhari is also a member of the Executive Committee of Pakistan Banks’ Association.

In the wake of rising costs of business, both in terms of risks and inflation, exploring new avenues of growth may be a challenging task. However, recent improvement in macroeconomic conditions and materialization of foreign aid will provide room for expansion for local banks...

Last two years have been extraordinary for the banking sector of Pakistan, in terms of obstacles and challenges. In the aftermath of global financial meltdown in 2008, the domestic economy came under stress. This coupled with political instability and security issues led to an adverse economic outlook. Backed by strengths gained over the last few years, presence of high quality capital cushion and effective systemic regulation from State Bank of Pakistan (SBP), the local banking sector has shown remarkable resilience in combating both domestic and international crises. Moreover, Pakistani banks had not entered in a big way the high risk sectors like consumer-oriented businesses and small and medium enterprises. Their portfolio was skewed towards corporate and public sectors. They had little exposure on derivatives and cross-country instruments. As a result, when compared with major global banks, their balance sheets were better able to absorb the shock when the global financial crisis struck. Now, in the wake of rising costs of business, both in terms of risks and inflation, exploring new avenues of growth may be a challenging task. However, recent improvement in macroeconomic conditions and materialization of foreign aid will provide room for expansion for local banks. The local banking sector received major setbacks during 2008-09. Successive increments in interest rates, high inflation and decline in economic growth to 2 percent in 2009 (from 4.1 percent in 2008) led to deterioration in asset quality and decline in profitability of banks. The corporate portfolio, which provides bulk of business to banks, took a hit in terms of rise in non-performing loans (NPLs). Although major bankruptcies were low, erosion of equity base of large businesses resulted in approximately 65 percent year-on-year increase in NPLs in 2008, out of which about 60 percent of incremental NPLs were in early stages of classification. Rise in NPLs and subsequent rise in provisioning charges led to a decline in the profitability of banks. Global crash of commodity prices towards the end of 2008 dented the textile sector, which accounts for a major portion of corporate loans of the banking system. The textile sector subsequently took more than six months to recover.



Another key strain on local banks’ resources was liquidity risk. Through the first half of 2008, the banking system carried excess liquidity; however, a number of factors caused liquidity to drain later in the year. First, despite witnessing over 15 percent year-on-year increase in remittance-based inflows and imposition of 5 percent minimum return on savings accounts, deposit growth remained stifled (approximately 10 percent growth in deposits in 2008 against about 20 percent increase in 2007) mainly due to stiff competition from National Savings Schemes, which offered higher profit rates. Second, continued increase in inflation, falling foreign exchange reserves (and value of the rupee) on account of lower foreign investment inflows and a period of unstable political transition led to loss of confidence in both the domestic economy and financial system. The situation was tackled in the short term by quick regulatory changes, such as easing of reserve requirements for banks. Moreover, Pakistani banks and large companies had accumulated significant reserves during the boom years and had sufficient cushion in their balance sheets to withstand the above challenges. Small borrowers are generally characterized by higher credit risk. Historically, financing small and medium enterprises (SMEs) has proven to be a risky venture for banks. In 2008, SMEs had NPLs to loan ratio of approximately 15 percent compared to about 10 percent for the corporate sector. Due to inherent risks in allocation of loans to SMEs, loan portfolio of banks is skewed towards larger corporate borrowers. As of 2008, less than 1 percent of borrowers with loan size PKR 10 million and above accounted for approximately 75 percent of total advances in the banking system, with approximately 65 percent of total loans to the corporate sector. However, the above lending practice increases credit concentration risk. The textile sector, with significant share in corporate loans, approximately 20 percent, had highest NPLs to total loans ratio of about 15 percent for 2008. Local banks, therefore, may need to explore ways to circumvent structural weaknesses of SMEs, as higher exposure to SMEs provides opportunity for banks to diversify their concentration risk. Despite going through a period of low profitability amid increasing NPLs and loan provisioning, effective regulatory framework has kept Pakistan’s banking industry on solid footing. Moreover, large Pakistani banks

have built extensive branch networks over many decades and have been able to develop very low-cost deposit base. In 2008, the Capital Adequacy Ratio (CAR) was above the minimum requirement of 9 percent under Basel II framework while core capital constituted more than 80 percent of total capital. Though total liquid assets for banks declined to approximately 30 percent (of total assets) in 2008 (compared to average of approximately 35 percent during 2005-2007), advances to deposits ratio was about 70 percent, indicating that banks were in a strong position to meet liabilities and remain solvent. On account of lower risk appetite of banks, CAR further improved in June 2009. The immediate concern for the banking sector will remain asset quality as it was the primary reason behind the fall in the sector’s profitability. Significant signs of improvement in asset quality remain to be seen. Until loan portfolio performance across the sector substantially recovers, banks will continue to focus on rationalizing costs to enhance their bottom line. A series of recent positive developments will likely provide platform for business growth. First, with global recession coming to an end, exportbased industry can start growing again. Second, banks are tapping opportunities in growing sectors like power generation and through lending to government. Third, expansion in agricultural credit provides avenue for business enhancement. During 2005-09, agricultural credit grew by about 20 percent annually while NPLs to loan ratio fell from 30 percent in 2005 to about 15 percent in 2009. Although lack of collateral and inconsistency in land revenue record pose major challenges to banks, growth in agricultural credit will allow banks to expand outreach and diversify their loan portfolio by increasing exposure to the rural economy. Fourth, consumer financing, which has gone through consolidation, can be re-ignited by stimulating housing finance as asset prices have stabilized. Lastly, expected foreign aid inflows (mainly under the ambit of USAID) will likely initiate growth in construction, electrical, automotive, materials and related industries in Pakistan.

PAKISTAN

Capital Markets Show Resilience

Mian Shakeel Aslam

Managing Director and Chief Executive Officer Lahore Stock Exchange

Mian Shakeel Aslam has a number of years’ experience in financial and capital markets, having worked with multinational institutions like KPMG and Merrill Lynch in the UK. He joined Lahore Stock Exchange in 2006 as General Manager/ Chief Operating Officer and assumed the position of Managing Director and Chief Executive Officer in 2008. In addition to being a Director on the Board of Lahore Stock Exchange, he has also been a Director on the Board of the Central Depository Company of Pakistan (CDC) and is serving on the Boards of the National Clearing Corporation of Pakistan, Institute of Capital Markets (ICM), and the Pakistan Credit Rating Agency (PACRA). Mr Aslam is an ACA from the Institute of Chartered Accountants of England and Wales (ICAEW).

With the government practising improved fiscal discipline, an increasing trend towards equity market investment has been seen. Also, a bourgeoning middle class of young and knowledgeable professionals is adopting an aggressive and proactive approach towards retirement planning, resulting in increased participation in savings and investment products...

Investing in emerging markets represents a high-risk, high-expected-return segment of the marketable equities universe. Defined as a group of countries with economies in an intermediate stage of development, neither undeveloped nor developed, emerging markets present a formidable array of potential rewards for the astute investor. In recent years, investors have enjoyed the opportunity to invest in an ever-expanding set of developing markets. Morgan Stanley Capital International (MSCI), a leading constructor of market indices, began tracking emerging markets in 1988 with an index of eight countries ranging from Mexico to Jordan to Thailand. By 1998, the total reached 28. In 2002, the Pakistan equity market was declared the best performing stock market in the world by MSCI and subsequently added to its Emerging Markets Index. Despite the negative publicity surrounding the country, the Pakistan capital market has progressed rapidly in the past decade, both in terms of returns and number of product offerings—from 1998 to 2008 the Pakistan capital market returned almost 30 percent per annum. Similarly, the range of product offerings has expanded to offer Automated Bonds Trading for both government and private debt, Deliverable and Cash Settled Futures, in addition to conventional common preference and rights shares. Other products in the pipeline include listed Real Estate Investment Trusts (REITs), Exchange-Traded Funds (ETFs), and Stock Options. Despite the recent global financial crisis and deteriorating law and order situation, the Pakistan equity market has rebounded sharply in 2010—up almost 100 percent from the lows of 2009. Additionally, the Pakistan equity market trades at a significant Price-to-Earnings discount to its regional peers and offers very high dividend yields, making it a very attractive investment option. The local equity market also exhibits low correlation with almost all developing and developed markets, making it a very effective tool for diversification—the concept at the heart of modern portfolio theory. Other exciting growth prospects include the in-progress demutualization of the stock exchanges, which will accelerate the development of the capital market through separation of ownership and trading rights, and the ongoing privatization of state enterprises, which will allow investor participation in highly profitable corporations and bring the benefits of private ownership to the newly privatized entities. The management and members of the Lahore Stock Exchange have encouraged and embraced automation; far ahead of their regional as well as local peers. Key achievements by the Lahore Stock Exchange in this regard include replacing the trading pit system with



an automated trading system in 1994, a first in Pakistan, and being the first exchange in the country to introduce Internet-based trading. Other important developments in which the Lahore Stock Exchange played a vital role were the establishment of the Central Depository Company in 1997, bringing the convenience, flexibility and transparency of electronic ownership of shares to the capital market participants and establishment of the National Clearing Company of Pakistan (NCCPL) to facilitate centralized clearing and settlement. One key reservation expressed by emerging market investors, both local and foreign, is lack of corporate governance. In Pakistan, this situation is quickly changing with the advent of the Pakistan Institute of Corporate Governance. More importantly, the listing regulations at all exchanges have been modified to include mandatory compliance of and training for corporate governance best practices by the listed companies. The investment landscape in Pakistan is dominated by institutions such as insurance companies, banks, mutual funds, brokerage houses, and government agencies. Some of the major participants are National Investment Trust (NIT), National Fullerton Asset Management (NAFA), AKD Securities, Arif Habib Securities, State Life Insurance Corp., Adam Jee Insurance, and EFU Insurance, to name a few. Foreign portfolio investment picked up during the boom years earlier in the decade; however, foreign funds were quick to cash out during the subsequent market fall. These crashes highlight not only the obvious—the volatile nature of the equity instrument—but also the obscure—the resilience of the Pakistan capital market, and emerging markets in general, to recover quickly and robustly. Some foreign investors seem to have realized this and we are witnessing a more stable flow of foreign funds in the equity market. Direct retail exposure is limited, although indirect equity market investment through mutual funds is picking up. The Mutual Funds Association of Pakistan (MUFAP), established in mid-1990s, reports almost Rs 200 billion ($2.4 billion) in assets under management. This is small considering the size of the economy but is expected to grow rapidly. A traditional barrier to investing in the capital market has been the very high returns offered by government securities —up to 22 percent per annum. However, with the government practising improved fiscal discipline, an increasing trend towards equity market investment has been seen. Also, a bourgeoning middle class of young

and knowledgeable professionals is adopting an aggressive and proactive approach towards retirement planning, resulting in increased participation in savings and investment products. Another trend that augurs well for the depth and liquidity of the capital markets is a move by several provincial governments and government agencies to fund future liabilities through capital market investments. Most notable in this regard is the Punjab Pension Fund set up by the Government of the Punjab. By hedging its future pension liabilities, the provincial government has set a precedent that others are sure to follow. Investor education is a key ingredient for the growth of any capital market as individual investors lack the resources to make informed decisions and develop rational risk-return expectations. Willingness and ability to bear risk need to be evaluated in the correct framework. Also, since bourses are markets for long-term capital, a long-term orientation is a critical ingredient for investment success. Unfortunately, in a developing country like Pakistan, where needs outstrip earning ability, some retail-investors do not approach the capital markets with rational expected returns consistent with their risk profile. Such a situation results in unfavourable outcomes for the uninitiated. Despite efforts in this direction by all stock exchanges, the need for an independent institution dedicated to capital market education was imperative. Towards this end, the Securities and Exchange Commission of Pakistan (SECP) in consultation with all the stakeholders set up the Pakistan Institute of Capital Markets with the objective of imparting accredited investment education to the market participants, achieving a key milestone in the development of capital markets. Perhaps, the most under-rated enabling factor for the growth of the Pakistan capital market is the huge untapped potential in the form of a large population, with most in the working age group and having limited access to financial services. This situation is expected to change as the ranks of the middle class will swell with increased social mobility. In my opinion, an educated pool of young professionals will be the core driving force for the growth of the economy and consequently of the capital market in Pakistan. In the 21st century, the shift of economic power from West to East looks inevitable. As a participant in this progress, I look forward to the opportunities and challenges ahead for the coming Asian age.

PAKISTAN

Volatility Is an Opportunity

Muhammad Farid Alam Chief Executive Officer AKD Securities Limited

Muhammad Farid Alam has over 20 years of experience in the financial sector. As CEO of AKD Securities, Mr Alam has been inspirational in keeping his team motivated and bringing out the best in them. Before joining AKD Securities in 2007, he was the Head of Mutual Funds Division and later on the Head of Treasury at Pakistan Industrial Credit and Investment Corporation (PICIC). Mr Alam successfully raised over Rs 3.4 billion during 2003-04 through right issues, which turned out to be a trend setter in the mutual fund industry. Before joining PICIC, he was the Head of Finance and Secretary to the Executive Committee and Board of Directors at CIRC, Ministry of Finance, Government of Pakistan. Mr Alam is a Fellow of Chartered Accountants (FCA) and serves on various committees. He has the honour of representing Pakistan in international forums and seminars held in London, Frankfurt, Malaysia, India, Singapore, and Hong Kong. Mr Alam regularly contributes articles on issues pertaining to capital markets and economy to various publications. He is often invited as an expert on various talk shows on business channels.

Going forward, KSE intends to diversify into derivative products such as Options and Swaps while ETFs and Tradable Sector Indices are also planned. Once these additional products are introduced, overall market volumes should increase alongside.

Introduction

There are three stock exchanges in Pakistan: Karachi Stock Exchange (KSE), Lahore Stock Exchange (LSE), and Islamabad Stock Exchange (ISE). KSE was incorporated on March 10, 1949 with just five companies listed on it. Today, there are 650 companies listed on the Exchange with a combined market capitalization of $33 billion. KSE had the honour of Chairing the South Asian Federation of Exchanges (SAFE) in 2009. The benchmark stock index in Pakistan is the KSE-100 Index.

Trading Volume Update

While a leverage mechanism has historically been in place since 2008, trading in local stock exchanges has been cash-based. This change coincided with the price floor imposed from late August to December 2008, in the wake of the global financial upheaval. Cashbased trading has resulted in average daily volumes falling to 190 million shares in 200910 from 260 million shares in 2006-07. That said, a leverage product is being contemplated and may be implemented shortly. At present, the Securities and Exchange Commission of Pakistan (SECP) and KSE have proposed separate leverage systems (Margin Financing suggested by SECP and Margin Trading proposed by KSE) and the reconciliation process is underway for a unified product. It is expected that such a product will be implemented in the first half of calendar year 2010. Besides enhancing market volumes in its own right, introduction of a leverage mechanism will likely negate the effects of the proposed capital gains tax. Currently, capital gains tax is applicable on banks (10 percent if holding is more than one year, 35 percent if holding is less than one year). A decision on the capital gains tax will be taken in the FY11 Budget (to be announced in June 2010). There are indications that if a capital gains tax is imposed, it will likely encompass a slab structure, with upper ceiling at 10 percent.



5 Years Progress 2006-2010

Total No. of Listed Companies Total Listed Capital (Rs) Total Market Capitalization (Rs) KSE-100 Index KSE-30 Index KSE All Share Price Index New Companies Listed Listed Capital of New Companies (Rs) New Debt Instruments Listed Capital of New Debt Instrument (Rs) Average Daily Turnover Shares (mn) Average Value of Daily Turnover (Rs) Average Daily Turnover (Futures) YTD Average Value of Daily Turnover YTD

Upto 29- Upto31-12- Upto 31-12- Upto 31-1212-2006 2007 2008 2009 652 654 653 651

Upto 3/2/2010 649

519270 2771114

671256 4329910

750478 1858699

814479 2705880

824258 2769620

10040.5 12521.54 6770.06 9 14790

14075.83 16717.1 9956.76 14 57240

5865.01 5485.33 4400.76 10 15312

9386.92 9849.92 6665.55 4 8756

9627.63 10026.99 6826.88 1 755

3 3400

3 6500

7 26500

1 3000

-

260.69

262.83

146.55

179.88

190.29

31611

25263

14228

7451

7563

82.68

61..69

30.76

1.03

3.62

13587.63

9077.61

522-.97

89.66

353.9

With the leverage mechanism and capital gains tax, if implemented, outlook for turnover over the long run is dependent on additional listings and some changes to the regulatory mechanism. At present, there are about 650 companies listed in Pakistan. However, recent changes to regulations such as book building mechanism (already implemented) should add to the market depth and breadth through additional listings. Luckily, the government is cognizant of the fact that during yesteryear when it divested shares of large-cap companies like Oil and Gas Development Company (OGDC) and Pakistan Petroleum Limited (PPL), it generated good interest and volumes as also raised Pakistan’s international profile. Going forward, similar steps with other companies should also enhance volumes. Moreover, the government has also initiated the process of granting shares of some governmentowned companies to employees. If this programme is carried out, i.e., if either some government-owned companies are listed or some float of already listed companies comes to the market, the same will add to the depth and breadth of the capital markets. Within the private sector, some companies have initiated the process of employee stock option programmes (ESOPs). Once these options are conferred, large illiquid blocks could come into the market.

From a regulatory perspective, additional volumes can also be generated if the existing ±5 percent daily circuit breakers are either widened or removed completely. India, for instance, has a cooling off period in place. At the same time, as the Pakistan capital market continues to mature, additional liquidity on the local bourses will be a natural outcome. In this regard, proposed demutualization of the stock exchanges is also a positive step.

Opportunity to Make Returns

The KSE-100 Index has witnessed a CAGR of 21 percent over the last 11 years (until June 2009), robust performance in itself. In fact, returns CAGR improves to 36 percent only if the period between 1998 and 2007 is considered. That said, a look at differences between KSE-100 Index highs and lows (within a fiscal year) yields average returns of 78 percent p.a. since 2000. Put differently, there is an opportunity to make significantly high returns if the Pakistan market is timed appropriately. By this metric, in comparison to the region, the Pakistan market depicts greater volatility than Malaysia, Philippines, Thailand, and even Sri Lanka. Index Volatility In Percent

2009

2008

2007

2006

Pakistan

104

167

48

40

Sri Lanka

126

82

30

56

86

133

52

34

Indonesia (JKSE)

106

161

73

55

Malaysia (KLSE)

54

90

33

26

Philippines (PSEI)

79

116

36

47

170

226

58

166

95

151

62

37

Russia (RTSI)

206

355

39

71

India (SENSEX)

118

176

66

60

89

z232

141

132

Thailand (SET)

Vietnam Brazil (BOVESPA)

China (SSEC)

This leads to another consideration. Investors could only take advantage of the 167 percent volatility in 2008 via shorting. Extending shorting throughout the market also has the potential to improve volumes.

Currently, KSE allows five markets to trade in: 1. 2. 3. 4. 5.

Ready Market Deliverable Futures Cash Settled Futures Stock Index Futures Debt Market

Most of the volume is concentrated in the Ready Market. Going forward, KSE intends to diversify into derivative products such as Options and Swaps while ETFs and Tradable Sector Indices are also planned. Once these additional products are introduced, overall market volumes should increase alongside.

Conclusion

Average daily market volumes have troughed at 180 million shares in 2009 and have since rebounded slightly to 190 million shares. A return to higher average daily volumes (>250 million shares) will be dependent on a few key developments: 1. 2. 3. 4. 5. 6.

Introduction of market leveraging product Implementation of capital gains tax Widening/Elimination of ±5% circuit breaker Allowing shorting on more scrips Introduction of derivative products Demutualization of stock exchanges

A Financial Technologies Group Initiative

FINANCIAL LITERACY

DIARY

Significantly higher volumes in yesteryear are testament to the turnover potential of the local bourses. Going forward, it is felt that if appropriate and conducive steps are taken, market volumes will only increase from hereon, thereby providing additional ease of entry and exit to investors and leading to even more enhanced price discovery.

KSE-100 High & Low 112% 61%

2000

167%

104%

95% 66%

44%

2001

39%

2002

2003

2004

2005

40%

48%

2006

2007

Financial Literacy assumes significance in the context of financial markets emerging as an important aspect of the global and domestic economies. It is in this background financial literacy initiatives assumed the stature of national level programmes in several countries, including India. Knowledge and awareness on the functioning of financial markets will greatly enhance the scope and level of investor participation, thus greatly enriching the significance of financial markets. It is with this objective that FTKMC published Financial Literacy Diary. The publication could serve as a diary, a source of reference, and above all a facility to record investments and update information. Financial Literacy Diary may bring markets closer to the investors by providing them with a better understanding on the functioning of financial markets and it is hoped that this Diary will emerge as an important accompaniment to them. FTKMC invites views and suggestions from readers and investors in making this Diary more useful and informative. For copies, write to: [email protected]

Partner Exchange

2008

2009


PAKISTAN

Fund Management Industry

Basharat Ullah Khan Chief Investment Officer Arif Habib Investments

Basharat Ullah Khan has 17 years of experience in the Pakistan capital market, including sell-side and buy-side research and equity dealing. Mr Khan oversees the asset management division and is responsible for managing AHI’s mutual funds. At present, AHI has Rs 17 billion ($ 200 million) of assets under management. He is responsible to devise and implement investment strategies and provide guidelines to fund managers. Mr Khan monitors investment activities and performance of each fund. He joined AHI in 2003 and is CIO since July 2008.

Despite the near-term challenges, the mutual fund sector is well positioned to be a strong growth area in Pakistan. The country has extremely low level of overall mutual fund penetration with even smaller share of household savings into mutual funds...

Like the rest of the world, the Fund Management industry in Pakistan, too, was badly hit in the second half of 2008 amid the global financial crisis pushing the local equities and bond market in turmoil. Assets under management (AUMs) witnessed a huge erosion of size from a peak of Rs 335 billion in April 2008 to Rs 150 billion in January 2009 due to falling asset prices and fleeing investors. Prior to this, the Fund Management industry witnessed rapid growth during 2005-08 with net inflows of over Rs 200 billion as new asset management companies were formed, new funds were launched, and headcounts were increased. The year 2009 witnessed sharp rebound in asset prices, most particularly equities, which gained over 60 percent. However, at the same time, mutual funds were unable to attract inflows in equity funds as investors throughout shied away from equity investments despite attractive valuations. As a result, equity funds got benefited from rebound in prices only and not so much from inflows. As of December 2009, total mutual funds size is Rs 184 billion, still much smaller than what it was in 2008. The industry continued to witness redemptions throughout the year despite improving equities and bond markets. Income funds, in particular, got hammered during 2009 as redemption pressure continued and some of the funds had to stop redemptions because of their inability to sell their illiquid assets consisting mostly lower-rated corporate bonds. The problems of troubled income funds had also impacted the otherwise well-managed funds as investors preferred to stay away from funds having any exposure to corporate bonds or other illiquid assets. Income funds have been investing in an array of asset classes such as corporate bonds, Continuous Funding System of KSE (investment in carryover trades of equities) and term deposits, besides government bonds and Treasuries. As long as new money was flowing into mutual funds, investments were made in assets without giving due consideration to quality and liquidity aspects. Emphasis during the period was only on generating higher returns irrespective of the quality of assets. Investors (mostly banks) were investing in funds on the basis of return performance only. This frenzy for higher returns caused them to pay a huge price subsequently. Only those income funds, which did not compromise on quality of assets, could ride through the crisis by meeting their obligations of redemption but not so much to stop the deluge of redemption. During the year 2007 and early-2008, fixed income funds (income funds) had grown at a phenomenal rate mostly on the back of money coming in from commercial banks. Income funds had become a dominant category, constituting almost 50 percent of the total size



of open-ended funds (in April 2008, the size of income funds was Rs 179 billion almost 53 percent of the total industry). As of December 2009, the size of income funds has shrunk to Rs 63 billion (42 percent of the industry). Banks had been the major class of investor in fixed income mutual funds in Pakistan and accounted for almost three-fourths of the industry’s fund size in 2008. They had been parking their surplus liquidity with mutual funds due to higher after-tax yields. At present, majority of banks have exited from income funds and only some of the large banks have investment, which is approximately one-third of the total fund size. Corporate and retail investors account for the remaining two-thirds of the income funds’ assets.

National Saving Scheme: A Major Impediment in Growth

This is by far the major impediment in mobilizing savings through mutual funds. National Saving Scheme (NSS) normally offers returns in excess of market-based returns and whenever domestic interest rates rise (as was witnessed in late-2008 and early-2009), there are huge inflows into NSS. During last fiscal year, NSS mobilized Rs 267 billion in new money (NSS schemes fall in the unfunded debt category of public sector debt and is now over Rs 1.3 trillion). Given the government guarantee and higher than market returns, bulk of the savings quite naturally goes to NSS. Most of the savings of Pakistani general public, provident funds, and pension funds are invested in this scheme. While steps were taken back in 2002 to curb institutional and corporate money in NSS, this restriction was lifted in 2008 as the government fiscal position deteriorated. Following the 2002 restrictions in NSS investments, mutual funds managed to attract inflows. Since 2008, once those restrictions were removed, the industry has seen major outflows. As long as this distortion remains and the government provides subsidy in the form of higher returns, the Fund Management industry will continue to struggle in making any significant inroads.

Categorization of Funds and Performance Reporting

A major development in 2009 was the categorization of mutual funds in a more systematic manner. The need to categorize mutual funds had arisen following the big run on income funds in 2008. Fixed income funds have now been split into three categories: cash funds, income funds, and aggressive income funds. Similarly, equity funds have been formally distributed in three categories: pure equity, balanced, and asset allocation. This classification has enabled investors to match and identify funds more closely to their investment objectives. One positive aspect of is that investors now first look at the quality of assets of mutual funds before any other aspects. This has resulted in improved fund performance reports, disseminating quality information

on portfolio, etc. For presentation of these reports, Mutual Funds Association of Pakistan (MUFAP) has devised a standardized format so that mutual funds provide vital information to investors on a regular basis.

New Products: Risk Aversion Is the Theme

During the recent months, cash funds have become favourites with investors and this is the only segment where inflows have picked up pace. The underlying assets of cash funds are short-dated Treasury bills. This largely reflects investors’ risk preference, which is predominately safety rather than return.

Voluntary Pension Scheme

One promising growth area is the voluntary pension scheme (VPS) introduced in 2007 and now being offered by four asset management companies (AMCs). At this stage, there are no mandatory pension schemes. Pakistani population has a small pool of long-term savings for retirement. A very large section of the population has no pension provisioning at all. Most of the corporate sector has only provident funds, where normally 10 percent of the gross salary with equal contribution by employers gets saved. Only a small number of the corporate sector (mostly large multinationals and banks) have funded pension schemes for the employees. Only the state and public sector employees are offered pension, which are mostly unfunded. VPS is a very flexible saving-cum-investment scheme that facilitates individuals to save for their retirement in a systematic way (in equities, debt, and money market sub-schemes), topping up their savings with investment returns at their desired investment exposures and granting them special tax benefits, with numerous valuable options before, at and after retirement. Despite the attractive nature of VPS, the progress in attracting any sizeable investment inflows has been rather small so far. One of the main reasons is that VPS providers have relatively small and weak distribution reach and hence they have not been able to create awareness for this product.

Performance Is Key Factor for Growth

The way forward is that the industry and its members will have to prove their credentials on their own. Well-established players in the industry have demonstrated to investors that mutual funds can deliver better and higher returns on a consistent basis. Those funds that have ridden well through the crisis (because of the quality of their portfolio) and which also managed to deliver higher returns have been the net beneficiary. On the positive side, the industry has now become more resilient, and there is a marked improvement in the performance of funds with a high focus on quality of assets.

PAKISTAN

Distribution and Retail Penetration

The mutual funds in Pakistan have a low level of retail penetration. This is mainly due to low customer awareness. The industry focus has mostly been on institutional business, which is relatively low cost, compared to retail, which involves high initial cost. Following sharp drop in AUMs in 2008, the process of opening and expanding retail and distribution presence was severely impacted. Banks, in general, have not taken any interest in selling or promoting mutual funds through their branch networks due to fear of losing deposits. Similarly, mutual funds distribution companies, which are small in size and having inadequate infrastructure, have done little on the retail front and they too are focusing on institutional sales.

Consolidation Is an Option

The sharp deceleration of business in 2008 forced the AMCs to rethink their business plan. The industry, whose revenues are directly related to FUMs while costs are relatively fixed, had to move fast to cut their expenses by shutting down distribution offices, laying off sales staff, and trimming overall operating costs. On one hand, cost cutting was important for ensuring the AMCs’ survival, at the same time it has severely restricted the business ability to reach out to clients. The size of total mutual fund assets is considerably small; it is just 6 percent of the banking sector’s total deposits and 1.5 percent of GDP. However, at the same time, there are a total of 24 AMCs in the field. The largest and oldest is the governmentowned National Investment Trust (NIT), which was established in 1962 and having AUMs of Rs 61 billion (one-third of the industry) by December 2009. AMCs sponsored by banks are 13. Most of the bank-sponsored AMCs were established after 2005. Banks have rushed to grab the slice of fund management business; however, little efforts have been made by these banks in building a distribution channel or using their extensive branch

network for selling of mutual funds. In fact, majority of bankbacked AMCs are surviving only on their banks’ investment in their mutual funds with only small base of other investors, such as retail and corporate. The other category is 10 AMCs backed by stock brokers, out of which two are prominent, having a wellestablished presence throughout Pakistan. One approach for the industry to move forward is through consolidation. With limited prospects of attracting huge amount of inflows, it will be difficult for most of the fund management companies to operate and survive with small fund size. For asset management business, size and efficiency are the key success factors. In the prevailing macroeconomic environment, business will continue to face headwinds; hence, AMCs will find it hard to be profitable if AUMs fail to grow. The more realistic approach can be through mergers or acquisitions, as it will help the merged entity to save on cost. Not only operating efficiency could be achieved, but large-size companies should be able to extend their reach in the market, which, at present, they are finding hard to achieve on their own.

Future is Promising

Despite the near-term challenges, the mutual fund sector is well positioned to be a strong growth area in Pakistan. The country has extremely low level of overall mutual fund penetration with even smaller share of household savings into mutual funds. Wellestablished players in the industry have demonstrated through their performance the benefits of investments/savings through mutual funds. More importantly, the industry is operating in a well-regulated environment with effective monitoring and oversight of the regulator to ensure systemic stability. The economic situation has started to stabilize and, given the positive demographics for the industry, it is expected that FUMs may grow at the rate of 15-20 percent over the next few years.


PAKISTAN

Growth of Depository Business

Muhammad Hanif Jakhura Chief Executive Officer Central Depository Company of Pakistan Ltd

Muhammad Hanif Jakhura joined CDC in 1994 and was General Manager till 2002. He was elevated to the position of CEO in March 2002. Mr Jakhura was also appointed as CEO of National Clearing Company of Pakistan Limited (NCCPL) in January 2002 and served in that position till September 2005. He is also Director, Institute of Capital Markets. He was the Chairman of the Committee to Review Institutional Arrangement for Financing Stock Brokers and Stock Market Investors. He was also the Chairman of Asia Pacific Central Depositories Group for the year 2006-07. Mr Jakhura is a Fellow Member of the Institute of Chartered Accountants of Pakistan (ICAP) and the Institute of Corporate Secretaries of Pakistan (ICSP). He has also successfully completed a certification course by Pakistan Institute of Corporate Governance for Certified Directors.

In Pakistan, the true potential of the mutual fund market remains unexplored. The introduction of more funds in the market is expected to attract investors in large numbers, benefiting the depository business...

Current Scenario

During the 1990s, the Pakistan capital market faced exponential growth in trading volumes, resulting in an unmanageable load on the then prevailing system of settlement. The manual system of securities settlement, with its handling of physical certificates, was simply too cumbersome and time-consuming and therefore completely incapable of supporting the market growth that was taking place. The Central Depository Company (CDC) was established with the objective of operating as a central securities depository and maintaining an electronic book entry system. The Company started operations in 1997. Functioning under a well-defined legal and regulatory framework that is laid down by the Securities and Exchange Commission of Pakistan (SECP), CDC operates and manages the Central Depository System (CDS) for equity, debt and other financial instruments that are traded in the Pakistan capital market. The system records, maintains, and registers the transfer of securities. It transfers the ownership of securities without any physical movement or endorsement of certificates or execution of transfer instruments. It also serves to link up the Issuers and Registrars of securities and the market for the purpose of executing corporate actions like disbursement of corporate benefits and carrying out mergers and splits. Through this system, CDC provides depository services to a wide range of capital market participants, such as brokers, asset management companies (AMCs), banks (including custodian banks), and general retail investors. It manages ordinary and preference shares, term finance certificates (TFCs) and other debt securities, Sukuk units of open-ended and close-ended funds, and Modaraba certificates. CDC is the sole entity handling the electronic (paperless) settlement of transactions carried out at all the three stock exchanges in Pakistan. Through the efficient functioning of CDS, continuous reduction in CDC charges, and aggressive induction of securities in the system, almost all securities traded and settled on stock exchanges are through CDS in book entry form. The current number of shares in CDS amounts to 70.64 billion with a market capitalization of around Rs 1,475.57 billion. Since inception, it has been the CDC’s objective to expand its product portfolio and introduce new products and services with the aim of promoting and facilitating further development of the Pakistan capital market. Brief details of the diversification that has taken place since 1997 into areas other than the traditional core depository operations are explained below.



The Investor Account Service (IAS) was launched in 1999. IAS allows retail investors to directly open and maintain accounts in the CDS. IAS accounts are under the complete control of CDC and are operated on direct written instructions of the IAS account holders. IAS effectively addresses the need for greater security on the part of retail investors. It has gained wide acceptance and has consistently continued its robust growth, which is evident from the fact that 30 percent of all shares held in CDS are held in IAS accounts. Further expanding the portfolio of services, CDC introduced its Trustee and Custodial services (T&C services) in 2002 for open-ended and closeended mutual funds and voluntary pension schemes being managed by the AMCs and pension fund managers. The prime responsibility of CDC as the trustee/custodian is to take into its custody all assets of the Collective Investment Scheme and hold them in trust on behalf of the unit/certificate holders. Over the relatively short period, which has elapsed since its introduction, the excellent service quality, professionalism, and adherence to rules and regulations have made CDC’s T&C services the preferred choice among AMCs in the country and currently provides these services to more than 100 funds managed by 30 companies with an aggregate fund size of close to Rs 200 billion. Launched in 2008, the Share Registrar Service (SRS) provides registrar and transfer agent services to issuing companies. This includes registration and verification of shares and records, handling of corporate actions and dealing with shareholders on behalf of issuer companies.

Market Development

Since its inception, development of the Pakistan capital market is among the core aims of CDC. Towards this end, and based on the remarkable improvement that has been brought about by CDS as regards the investment trends in the country, CDC has continuously been making efforts to educate investors, both at home and abroad, on the advantages of investing in the capital market in Pakistan. In this connection, CDC has been conducting investment road shows in major cities in Pakistan—Sialkot, Peshawar, Hyderabad, Quetta, Multan, Sukkur, Faisalabad, Gujranwala and Lahore—and abroad—New York, London and Dubai. These events play a key role in increasing awareness about stock market investment. Another benefit provided by these events is that they provide a platform for investors and stakeholders to seek advice from representatives of stock exchanges, CDC, SECP, and brokerage houses.

Future Prospects

The main factor influencing the growth of depository business is the expansion of the Pakistan capital market. The growth of the market will, in turn, be dependent on the following factors. 1.

Increase in Retail Investor Base

One of the most important objectives is to help increase the number of retail investors in Pakistan. A significant increase in this number

can, in fact, revolutionize the future outlook of the country’s capital market. To explore the real potential of retail investors, large-scale and joint efforts are required to be made by all segments of the capital market. These efforts, if focused on improving the confidence of potential investors, educating them about investment trends, and promoting an investment culture, can help attract retail investors towards the stock market. 2.

Enhancing Market Depth

3.

Introduction of New Products

4.

Growth of Mutual Fund Industry

5.

Dematerialization and Settlement of Warehouse Receipts

Another serious surge in capital market investment trends is expected to arise by increasing the market depth for large-scale investments from both local and foreign investors. Creating new and large-volume listings on bourses and privatization of government-owned organizations is the real way towards increasing this depth. The recent increased focus of the Pakistan government on privatization of state-owned assets has certainly resulted in increased investor interest. A better environment would be created for the improvement of investment patterns through the introduction of new products. The size of depository operations will be positively affected by the introduction of new products that are settled through CDS. One such example comes from the recent launch of National Savings Bonds by the government, which has been issued completely in scrip-less form and will be settled through CDS. The growth of the mutual fund industry will benefit not only the core depository business but also in increasing the revenue earned by CDC’s T&C operations. Mutual funds are fast becoming the preferred choice of investors as a relatively secure investment option worldwide. Today, thousands of mutual funds exist worldwide with trillions of dollars in assets. However, in Pakistan, the true potential of the mutual fund market remains unexplored. The introduction of more funds in the market is expected to attract investors in large numbers, benefiting the depository business.

With the increase in activity in the commodities futures market and the establishment of a national level multi-commodities exchange, a need is being felt in Pakistan for an efficient settlement system in this market. CDC is actively looking into the induction, in bookentry form, of the warehouse receipts into CDS, thereby extending depository services for settling trades in commodity futures. This will greatly extend participation in the depository business in Pakistan and will also enable CDC to expand its activities.

SRI LANKA

Colombo Stock Exchange

Exchange Industry

Other Asset Classes

Exchanges


N/A

Commodity Markets

N/A

Stock

Number

1

Banking

Capital Markets

Regulator

Name

Central Bank of Sri Lanka

Licensed Commercial banks

Number

22

Regulator

Name

Securities and Exchange Commission of Sri Lanka

Brokers

Number

21

Domestic Bank

Number

11

Registrars

Number

25

Foreign Bank

Number

11

Custodians

Number

16

Licensed Specialized banks

Number

14

FIIs

Number

5262 Foreign Companies have been registered in CDS

ATMs

Number

1825


%

14.9

Prime Lending Rate

%

8.5

Bank Assets to GDP

%

58

Depositories

Number

1

Demat Accounts

Number

496907

Companies Listed

Number

232


$ mn

9580.1



%

123.40

Regulator

Name

Securities and Exchange Commission of Sri Lanka


%

46

Fund Houses

Number

5

Turnover (2009)

$ mn

1246.4

Total AUM

Sri Lankan Rupees billion

7.5


%

29


16.5

Products Offered

Equities, Corporate Bonds, Warrants & Debentures

Settlement Cycle

T + ….

T+3