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The Surge in Karachi Stocks
The Karachi Stock Exchange Index (KSE-100) blasted through the 4000 mark last week to a new record high. For a market that spent most of the 1990¹s in the doldrums while the rest of the world surged, the last two years have been quite a turnaround. Right after September 11, 2001, the KSE-100 was only at about 1300, but it doubled in value over the next twelve months and has been the best performing stock index on the planet over the last two years. Few observers would have predicted this surge after the Trade Center attacks, as it was hard to see how a war in Afghanistan and a wave of Al-Qaeda terror in Pakistan could be anything but bad for the country.
But investors were much smarter, and realized that Pakistan¹s geostrategic fundamentals had changed in a permanent and better way. After 9/11 the alliance with the US was reborn, export quotas for textiles to the EU and US were increased, remittances surged into the formal channels, the rupee rallied 10% in value, and the country¹s crushing external debt was substantially lightened in a major debt rescheduling in December 2001.
But these changes by themselves do not explain the surge in the market. Along with improving external factors, internal reforms were paying dividends. Pro-free market policies, rational bank lending by professional managers, sounder fiscal policies, improved tax collections, and privatizations convinced investors that Pakistan¹s private sector prospects had fundamentally improved. The clinching factor was a sharp drop in interest rates due to record low inflation and the wise leadership of Ishrat Hussein as head of the independent central bank.
Stock prices over the long term are based on three factors, the level of corporate earnings, the rate of interest on risk-free investments (essentially short-term government bonds) and the equity risk premium that investors demand for holding riskier stock investments. In Pakistan all elements improved dramatically over the last two years. Pakistani companies reported record profits in 2002, and returned much of that profit to shareholders in record dividends. Karachi Stock Exchange listed stocks paid out 61 billion rupees in dividends last year, a 50% increase over 2001. Given that the market value of the Karachi stocks totaled 600 billion rupees, the dividend yield was a very fat 10%. Compare that with a 1.8% yield on American stocks, and one can see why Pakistani stocks were generating so much interest.
Short-term government interest rates on Pakistan Investment Bonds declined to 2.5% over the last two years. This has made alternative investments more attractive as very little return was to be had in safe government debt. The equity risk premium has also declined because the risks in Pakistan¹s economy have subsided. The removal of American economic sanctions was one big plus, and recently the thaw in relations with India reduces the risk of war that was factored into stock prices. Some observers in Pakistan believe that the equity risk premium should be about 4%, meaning that stock dividends should be about 4% higher yielding than government paper. This means that fair value on the stock market would be a dividend yield of 6.5%. Given that dividends this year are coming in substantially higher than last, and assuming that investors bid stocks up high enough to drive the dividend yield down to 6.5%, the KSE-100 could top 5500 by the end of the year. Over the next two years the stock market could reach 7000, and still be valued much less highly than the US market, although that is mainly due to the much lower equity risk premium American investors require. Pakistani policy makers are trumpeting the rise in the KSE. Musharraf mentioned it in his speeches as he toured the West in July. But Pakistan¹s political class may find that the surge in the KSE is a straitjacket for their policies. At current levels, Pakistani stocks are worth 15 billion dollars, meaning that 10 billion dollars have been added to the net worth of owners of KSE stocks. As there is very little foreign ownership, this means that a powerful constituency of stockowners in Pakistan is sitting on tremendous new wealth. Their primary political goal now is to see their investment protected, which means they will view dimly policies that will depress stock prices. This wealth-motivated constituency will want an end to regional conflicts and a completion of the free-market reforms of Shaukat Aziz. They will want these things not out of liberal or conservative convictions, but because these policies will protect and enhance their wealth. If the market doubles again over the next three years, which I think is possible if good foreign and economic policies are followed, this constituency will become very hard to ignore.
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