KARACHI STOCK EXCHANGE DROPPING WITHOUT FLOOR

UNCLAS SECTION 01 OF 02 ISLAMABAD 003888


SENSITIVE
SIPDIS


E.O. 12958: N/A
TAGS: ECON ETRD EAID EFIN ENGY EINV PGOV PK
SUBJECT: KARACHI STOCK EXCHANGE DROPPING WITHOUT FLOOR


1. (U) SUMMARY: Beginning Monday, December 15 the Government of
Pakistan (GOP) required the country's three exchanges to remove a
restriction ("floor") on trading below closing prices of August 27,

2008. The Karachi Stock Exchange (KSE) dropped approximately 4
percent during each of the first four days of trading, passing its
lowest point since September 1, 2005. Analysts estimated the market
has been overvalued by 40 percent. An exchange regulation that
strictly limits the amount share prices can move each day has slowed
the market decline but has also made finding fair market prices very
difficult. Meanwhile, the GOP and the International Monetary Fund
(IMF) finally reached consensus on a limited stock market support
scheme of USD 250 million. END SUMMARY.


2. (SBU) On August 28, the KSE announced a trading restriction that
prohibited listed shares from being traded below the closing price
on August 27, following a plunge of 42 percent from the market's
high on March 21. The "floor" on market prices effectively halted
trading on the KSE although off-market, unregistered trading
continued. Initially labeled a short "breathing space", after more
than 100 days the floor is now described by the Pakistani press as
the longest closing of a stock market in history. The Securities
and Exchange Commission of Pakistan required the three exchanges of
Pakistan to remove the trading floor as of Monday, December 15. The
KSE dropped approximately 4 percent during each of the first four
days of trading. After the tumble on December 18 the KSE hit its
lowest point since September 1, 2005.

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MARKETS WILL LIKELY CONTINUE TO RATCHET DOWN
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3. (U) Despite these drops, the market still has not reached
equilibrium. On the day the floor was removed the Karachi 100 Index
traded at 9.9 times earnings, compared to the Morgan Stanley Core
Index (MSCI) Emerging Markets Index's average of 8.3 times, making
Pakistan Asia's fourth-most expensive market. Citibank analysts
estimated the market was 40 percent overvalued at the time the floor
was removed, and would decline to be closer to parity with other
Asian markets. The MSCI AC Asia Pacific Index has fallen 31 percent
since the floor was first imposed. On December 10, MSCI announced
that Pakistan will be removed from the MSCI, effective December 31,
which will force many index funds to sell Pakistani shares and
further hurt Pakistan's equity market.


4. (SBU) KSE's Managing Director, Adnan Afridi, confirmed to EconOff
that the KSE has not experienced a huge wave of panic selling
because a "circuit breaker" mechanism is choking trade. He said
that, following September 11, 2001, the KSE enacted a rule
prohibiting the trading of stocks beyond a band of five percent
above or below the opening day's share price. (Note: Bloomberg
reports, and evidence suggests, that the rule actually permits
stocks to decline 5 percent or 1 rupee, whichever is higher. End
Note.) Afridi explained that the activity during the first days
without the market floor were small trades (as little as 100 shares)
to daily move the price down by the full amount permitted by the
circuit breaker rule, and that trading will rapidly increase as
shares approach competitive market valuations.

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BAIL-OUT FUND
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5. (U) Following the establishment of the market floor, many
investors had hoped for a government bailout package designed to
support stock prices. The GOP proposed two measures, the first
would cost PKR 30 billion (USD 373 at 80.5 Pakistan rupees per USD)
and entail offering foreign investors "put options", or the right to
sell shares at a predetermined price. The second was a PKR 20
billion fund (USD 248 million),financed by private banks with a
public guarantee, which would purchase shares of eight state-owned
enterprises (SOE). As part of a USD 7.6 billion IMF program
beginning November 24, Pakistan agreed to consult with the IMF
before implementing any stock market support scheme.

ISLAMABAD 00003888 002 OF 002




6. (SBU) On December 16, Pakistan announced it will establish the
USD 250 million fund to buy listed SOE's shares after the market
falls to its new equilibrium. IMF representatives had said they
were opposed to the use of public funds to assist wealthy, private
investors. However, the GOP revised the original proposal to
eliminate the put-options fund and modified the SOE share-purchase
fund so that it would not buy shares at above market prices
selectively from some investors. IMF management remains reluctant,
but the potential fiscal cost involved (a total of 0.2 percent of
GDP distributed over a few years) is not large enough to be critical
to macroeconomic stability.

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FOREIGN PORTFOLIO INVESMENT WILL DROP
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7. (U) Financial analysts estimate that foreign portfolio investors
have approximately USD 1.8 to 2.2 billion invested in Pakistani
equity markets but that USD 500 million to 1 billion will be
divested and expatriated now that the floor has been removed,
draining scarce foreign exchange. Pakistan's two-year program
agreement with the IMF loan agreement included an initial tranche of
USD 3.1 billion. This infusion lifted foreign exchange reserves
held by the SBP from USD 3.5 billion (less than one month's imports)
to USD 6.01 billion as of December 15, but requires that the GOP
maintains net foreign assets above predetermined levels to remain
eligible for the remaining loan tranches. Huge outflows of
foreign-owned assets will make it harder for the GOP to meet the IMF
program performance criteria.


8. (U) COMMENT: As constructed, the circuit breaker causes
stagnation in Pakistan's equity market. If such a safety mechanism
is necessary, it should apply to an index rather than each
individual company share price, and thereby protect the market from
either euphoria or panic. The current formulation simply inhibits
accurate pricing.


9. (U) COMMENT CONTINUED: The fund to purchase shares of SOEs is
also poorly conceived. By interceding only after the market has
reached its new equilibrium, the publicly guaranteed funds will have
a negligible effect on market sentiment. Implementation of the
support scheme looks increasingly like fulfillment of a promise by
the ruling Pakistan People's Party to save political face. END
COMMENT.

PATTERSON