KARACHI STOCK EXCHANGE - REFORMS, HOPES, CHALLENGES

C O N F I D E N T I A L SECTION 01 OF 02 KARACHI 000361

SIPDIS

E.O. 12958: DECL: 11/13/2019
TAGS: EFIN PGOV ECON PK

SUBJECT: KARACHI STOCK EXCHANGE - REFORMS, HOPES, CHALLENGES

Classified by: Consul General Stephen G. Fakan, Reasons 1.4 (b)and (d)


1. (C) Summary: In the wake of Pakistan's 2008 financial collapse,
the Karachi Stock Exchange (KSE) is introducing viable leverage
products and debt liquidity, implementing stringent safeguards
against market manipulation, and pursuing demutualization - through
decoupling exchange ownership and trading rights. KSE and Security
and Exchange Commission officials told Econ Offs these reforms will
establish a more stable and modern trading platform, capable of
attracting both foreign and domestic investment. Despite these
officials' optimism, institutional malaise, cronyism, and a lack of
political will threaten to impede reform efforts. End summary.

2008 Market Collapse
--------------

2. (U) Pakistan's 2008 economic collapse had a significant impact on
the Karachi Stock Exchange (KSE),with total market capitalization
plummeting from a high of $78 billion in 2007 to approximately $33
billion today. Daily trading activity also dropped from $500-600
million to approximately $300 million over the same period. From
August to December 2008, the government imposed a floor on KSE to
prevent further declines. However, the market has shown recent signs
of recovery, with increased trading volume and a positive trend in
portfolio investment. There are also several initiatives underway
that have investors and the KSE management optimistic about the
future of the exchange.

Demutualization is Coming
--------------


3. (SBU) On October 13, Adnan Afridi, Managing Director of the KSE,
told Econ Offs that "demutualization, through decoupling the broker's
ownership of the exchange from their trading rights, is the key to
modernizing the capital markets." (Note: Demutualization is the
process by which a customer-owned mutual organization or co-operative
changes legal form to a joint stock company. End note.) Afridi
believes demutualization will increase both market transparency and
efficiency, and will inject much needed capital into the KSE.


4. (C) The first step, diversification of the KSE Board of Directors,
was implemented in 2007 to counter claims that the KSE was operating
as a monopoly and that the 200 brokers, who both own and have
exclusive trading rights on the exchange, were blatantly manipulating
the market. An independent chairman and managing director were
appointed to guide day-to-day operations of the exchange and
independent businessmen were given seats on the Board to help balance
the interests of the brokers. However, according to Mateenullah
Khan, Joint Director for the Securities Market Division (South) of
the Securities & Exchange Commission of Pakistan (SECP),changes to
the Board have not been fully effective in preventing cronyism and
manipulation, as many brokers retain close relationships with the
independent members of the Board and are able to either influence or
outmaneuver them when disagreements arise.


5. (U) On October 11, the National Assembly passed a bill that would
finish the process of demutualization. Under the provisions of the
bill, the 200 brokers who currently own the KSE would sell 40 percent
of their equity to "strategic international partners" and an
additional 20 percent to private investors, leaving the brokers with
a 40 percent ownership stake. The bill must still pass the Senate
before it becomes law, and the changes implemented.

Return of Margin Trading
--------------


6. (U) Plans developed jointly by the KSE and the SECP in accordance
with international standards and best practices to re-introduce
margin trading, suspended in 2008 due to its perceived role in
contributing to the market crash, are moving ahead. Unlike the Badla
system (an indigenous "carry-forward" finance system where brokers
were the sole financers) the new system would standardize broker
requirements and allow non-broker entities, such as banks, to provide
leverage financing. The proposal also includes safeguards such as
equity requirements, "circuit breakers" (designed to prevent the
collapse of securities),and an online investor tracking system to
limit fraud. The SEC has approved this system which is expected to
be fully implemented within the next six months.



KARACHI 00000361 002 OF 002


Happier Days Ahead?
--------------


7. (SBU) Arif Habib, former chairman of the KSE and CEO of one of
Karachi's largest investment banks, believes Initial Public Offerings
(IPOs) will play a major role in future market capitalization. In
the past, IPOs were not seen as viable because of the loose lending
standards and low interest rates offered by banks. However,
following the 2008 financial crisis, banks have tightened lending
requirements, reducing the sources of cheap debt, and increasing the
competitiveness of IPOs. Habib expects that in FY 2009-2010 there
will be between 15 to 20 IPOs, compared with zero during the FY
2008-2009. (Note: There have been three successful IPOs thus far
this year, and four more are in process. End note.) The KSE is also
planning an aggressive outreach campaign to the largest 100 companies
in Pakistan to urge them to use private financing and to convince the
government to divest more of their 27 percent market share.


8. (SBU) On November 2, the KSE launched its Bond Automated Trading
System (BATS). This introduced the trading of debt market securities
to Pakistan's exchanges. According to Anita Mirza, KSE Head of
Marketing, the new system is being well received by brokers. During
the first day of trading, Rs 40 million ($500,000) of transactions
for term finance certificates from 24 companies were conducted.
Mirza described the day as "very successful," and said the value and
number of transactions, and companies, will increase as the market
develops.

Comment
--------------


9. (C) Despite optimism regarding these ongoing reforms, many threats
remain to the long-term viability of Pakistan's financial system.
While portfolio investment has stabilized, foreign direct investment
remains well below 2007 levels. Afridi cited a lack of investor and
broker knowledge of the current market and proposed enhancements,
stating that such institutional malaise threatens reform efforts.
Meanwhile, Khan expressed concern over Pakistan's antiquated legal
framework and a lack of political will to implement needed reforms.
Finally, terrorism, with its debilitating impact on the market's
stability, remains a significant unknown to the future viability of
the KSE.

FAKAN