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Development of capital markets.

Capital Markets play a very important role in the economic growth of countries by channeling savings into the most promising investment opportunities. A market based economy needs financial markets which are free to price and allocate capital efficiently and in the process transmit efficiency to the real sectors of the economy. However, to develop efficient and dynamic capital markets it is essential that a proper climate is ensured. Governments can lay the foundation for capital market development by establishing an effective policy framework. The elements of such a frame work include:

a) Implementing consistent policies that encourage use of long term financing by corporate entities.

b) Removing disincentives or establishing incentives to increase the demand for securities by individual and institutional investors.

c) Providing necessary protection to investors to increase their confidence.

d) Organizing and improving the financial intermediation process in the primary and secondary market.

e) Improving disclosure and accounting standards to provide more reliable information to investors and;

f) Removing legal barriers to market development.

Keeping in view the above elements we can analyse the development of the capital market in Pakistan. The principle of following consistent and uniform policy for encouragement of use of long term finance has been followed to a certain extent only. All Governments have tried to encourage long term financing by giving various incentives. One of the major incentives given in the last ten years has been the protection from foreign exchange value fluctuations by prescribing a Foreign Exchange Risk fee. However, this was to safeguard the investors from consequences of fluctuations of foreign loans. Other incentives and policies have had an indirect bearing on the use of long term financing like exemption of certain bonds from income tax and zakat. But again it has not been a uniform policy and has been rather selective. To encourage the bond market, such incentives need to be given to all bonds which are floated, even by the private sector, on a uniform basis or not to any one individually. Again fiscal policies must be consistent and any variations can disturb the development of the market. An example of such inconsistent policy is with regard to the taxation of dividends. It was not taxed initially, later on it was to be taxed at 7-1/2 per cent of such income above Rs. 15,000. It was increased to 10 per cent and later on the limit was also removed. But perhaps the most glaring inconsistency in Government policy has been the withdrawal of Income tax, exemption status from the Modarabas. This exemption was given through a low and implied permanency. It was intended to promote an Islamic mode financing but the moment it started taking off, the exemption was withdrawn.

The second principle regarding removal of disincentives and grant of incentives to increase demands for securities has been more consistently followed. Every Government has tried to give more and more incentives to encourage the securities market. The present Government has gone beyond incentives encouragement and has removed the disincentives in the way of development of the capital market in Pakistan. The previous Governments had financial structural policies which favoured deposit banks and Government securities in general and thus slowed the growth of securities markets. The establishment of commercial banks, investment banks, leasing institutions and mutual funds in private sector were made difficult, although they were the key securities market savings mobilization and allocation institutions. The present Government has adopted policies which are aimed at liberalizing the financial markets. Measures taken by it in this connection which have encouraged the development of capital markets include:

a) Privatization policy of the Government and expansion of the corporate sector whereby areas hitherto reserved for public sector were opened to the private sector. Thus commercial banks, investment banks and leasing companies are being liberally allowed in addition to privatising some of the public held banks like MCB and ABL.

b) Deregulation of the economy by removing a number of disincentives like abolition of licences lengthy sanctioning procedures and doing away with obtaining of No Objection Certificates and liberalising pricing of shares.

c) Liberalization of the foreign exchange regulations and opening of the capital market to foreign investors.

d) Extension of the capital gains tax exemption up to June 1995.

e) Introduction of simplified tax collection system by extending the withholding tax concept.

f) Bringing uniformity in tax on dividends and interest income.

g) Allowing the private sector to set up open ended and closed ended mutual funds.

h) Permission to set up Employees Stock Option Schemes.

i) Reducing the withholding tax from 30 per cent to 10 per cent for NRP and thus removing the differentiation in tax between NRP and RP.

j) Raising the exemption limit for issuance of capital from Rs. 50 million to 100 million.

As regards providing protection to investors in order to increase their confidence the present Government has taken a number of steps:

a) Promulgation of the Protection of Economic Reforms Ordinance (No. XXVI) of 1991 in order to create a liberal environment for savings and investment. It provides protection in the following manner:

i) Freedom to bring, hold, sell and take out foreign currency by all citizens of Pakistan and outsiders. Thus foreign currency accounts can be maintained both inside and outside Pakistan without question being asked by the taxation authorities about its source. The balances and incomes in such accounts would be exempt from levy of wealth tax, income tax, and zakat deduction at source.

ii) Protection of fiscal incentives for setting up of industries.

iii) Protection of foreign and Pakistani investment in industry and share market.

b) Forward trading has been suspended due to heavy speculation in the cleared list.

c) Steps have been initiated to curtail the high incidence of multiple applications for new floatations.

d) Inquiries and inspections have been held into the accounts of about 11 modarabas and one leasing company in order to properly regulate these sectors.

e) Official inquiries into accounts of some leading brokers to ensure prompt response to demands of investors.

As far as organizing and improving the financial intermediation process in the primary and secondary market is concerned, a number of steps have been taken. These include sanction of a number of investment banks, Investment Advisers, Leasing Companies and Modarabas in the private sector. To improve the process, qualifications have been laid down for brokers, courses have been organized for them while their accounts are now being regularly asked for and audit thereof carried out. A number of inquiries are being held into the lapses on part of brokers in order to improve their working. The stock exchanges have started self regulation besides providing better facilities to their members like computerized trading and better working space and working conditions. In order to improve the secondary market, the time period for registration of shares has been reduced, the requirement of allotment letter dispensed with and foreign investors were allowed the same treatment as local for sale of shares through the transfer deed. Another major step being taken in this respect is the effort to set up a Central Depository. The proposal is in an advance stage and would improve the system tremendously.

In order to improve disclosures and accounting standards so as to provide more reliable information to investors, again a number of measures been taken:

a) To ensure proper disclosure, the past performance of companies on whose boards the present issuers/sponsors directors have worked must be given for the last five years. This has been done to highlight the past performance of the sponsor directors.

b) Risk factors have to be disclosed in order to appraise the potential investors of possible areas of risk being visualised by the company.

c) In case of modarabas the same person cannot be on the boards of two modarabas while all directors must have clean records and as such have to give affidavits to this effect.

d) No second modaraba is allowed unless accounting results of three years of the previous modaraba are available.

e) All modaraba loans (Musharka, Murabaha and P&L) have been made subject to the following conditions:

i) The modaraba must disclose in its accounts all loans exceeding 20 per cent of paid up funds.

ii) It will also give an edged analysis of receivables along with efforts made to recover the same.

iii) No accommodation to be made to directors, chief executives, sponsors their spouses and lineal ascendants and decendants or to firms and companies in which they have an interest as a partner, director or shareholder.

f) Similar information has also to be provided for leasing companies. In addition:

i) Accounts of leasing operations shall have to be maintained as per IAS 16.

ii) The exposure of leasing companies to a single group is not to exceed 20 per cent of the paid up capital and reserves.

iii) All leasing companies must disclose all loans exceeding the above percentage and;

iv) Disclose all loans taken by it and use of such loans during the year.

Legal barriers to market Development have been removed by issuance of appropriate legal orders. Thus while the Protection economic Reforms Order, 1991 gives protection to the economic reforms, subsidiary changes in other laws to facilitate market development have also been made. The Capital Issues (Exemption) order has been amended as has been the tax law through the Finance Act, 1992.

It will thus be seen that efforts have been made to develop the capital market in Pakistan on sound lines. The result has been the tremendous growth in the stock market during the last one year. It has withstood the assaults of various adverse circumstances and where the market fell it did so gradually without resulting in a crash. It has shown its resilence time and again and we hope it will continue to flourish.
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Author:Abdullah, Mian Mumtaz
Publication:Economic Review
Date:Oct 1, 1992
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