The Economy of Pakistan:

The economy of Pakistan is the 43rd largest in the world in nominal terms and 25th largest in the world in terms of purchasing power parity (PPP). Pakistan has a semi-industrialized economy, which mainly encompasses textiles, chemicals, food processing, agriculture and other industries. Growth poles of Pakistan's economy are situated along the Indus River; diversified economies of Karachi and Punjab's urban centers coexist with lesser developed areas in other parts of the country. The economy has suffered in the past from decades of internal political disputes, a fast growing population, mixed levels of foreign investment, and a costly, ongoing confrontation with neighboring India. However, IMF-approved government policies [citation needed], bolstered by foreign investment and renewed access to global markets, have generated solid macroeconomic recovery the last decade. Substantial macroeconomic reforms since 2000, most notably at privatizing the banking sector have helped the economy. GDP growth, spurred by gains in the industrial and service sectors, remained in the 68% range in 200406 due to economic reforms in the year 2000 by the Musharraf government. In 2005, the World Bank named Pakistan the top reformer in its region and in the top 10 reformers globally. Islamabad has steadily raised development spending in recent years, including a 52% real increase in the budget allocation for development in FY07, a necessary step toward reversing the broad underdevelopment of its social sector. The fiscal deficit the result of chronically low tax collection and increased spending, including reconstruction costs from the devastating Kashmir earthquake in 2005 was manageable. Inflation remains the biggest threat to the economy, jumping to more than 9% in 2005 before easing to 7.9% in 2006. In 2008, following the surge in global petrol prices inflation in Pakistan reached as high as 25.0%. The central bank is pursuing tighter monetary policy while trying to preserve growth. Foreign exchange reserves are bolstered by steady worker remittances, but a growing current account deficit driven by a widening trade gap as import growth outstrips export expansion could draw down reserves and dampen GDP growth in the medium term

FINANCIAL MARKETS:
Financial markets include all markets where transactions relating to the trading of financial securities and extending credit take place. The following sections provide an overview of financial markets in Pakistan by highlighting the Pakistan capital market i.e. equity and debt market characteristics. It also explains the state of affairs of nonperforming loans in Pakistan, its impact on the overall economic activities.

AN OVERVIEW OF FINANCIAL MARKETS IN PAKISTAN:

Financial Market Development is key driver of economic activity. In seventies, governments nationalization policy paved the way for political control on different established private sector companies and banking sector. The same continued till nineties. A new institution named as Pakistan Banking Council emerged for operational control of banks. The Federal government was given the authority for selection of PBC members, whereas PBC had the authority to appoint board members of individual banks.

In Pakistan where industrialists have powerful influence and affiliations with political parties this structure has been misused. Discussed that in eighties and nineties, the industrialists availed the rate of interest on loan at forty percent of the open market interest rate. Subsidized credit continued to provide essential state-created incentives for corporate growth during the eighties and nineties. There are still some privileged sectors getting subsidized loans. In July, 2006 State Bank of Pakistan reduced the interest rate for financing to textile industry by 3 percent whereas the government was already providing subsidy for financing export oriented project by 6 to 7 percent5. Hence the textile and other export product producers were getting loans which were 10 percent less than the market rate. This pattern of corporate finance reduced the incentive to mobilize capital through equity and public debt markets, which in turn might be the reason for underdevelopment of capital markets in Pakistan Furthermore instead of creating efficiency by the provision of subsidized loans; it increased the proportion of debt in the 5 Pakistan Economic Survey 2006-07, Government of Pakistan, Finance Division, Economic Advisors wing, Islamabad. Capital structure beyond the optimal level. Firms operating expenses increased and resulted in losses. This state of operation increased the non-performing loans of the financial sector of Pakistan. Markets for sale and purchase of stocks (shares), bonds, bills of exchange, commodities, foreign currency, etc., which work as exchanges for capital and credit in known as financial market. A financial market is a process that allows people to easily buy and sell financial securities, commodities items of value at low transaction costs and at prices that reflect efficient markets.

Pakistan Financial markets comprise of: 1. Capital Market. 2. Money Market

1.

Capital Market:

The market in which corporate equity and longer-term debt securities (those maturing in more than one year) are issued and traded. Financial instruments traded in the capital market include shares, and bonds. Capital markets, and especially the stock markets in Pakistan, have come a long way over the last decade. Since 1991, when the boom first resulted from the liberalization policies of the government at the time, we have seen many major developments such as a manifold increase in the number of listed companies and the traded volumes, introduction of automated trading and settlement systems on the pattern of the world's modern stock exchanges, as well as intensifying competition for the business evident from the quality of research being published and distributed.

Stock exchange:
The place where bonds and stocks are exchanged. Its basic function is to enable public companies, governments and local authorities to raise capital by selling securities to investors. Presently, in Pakistan there 3 markets, mainly in Karachi.

Stock Exchange in Pakistan:

In Pakistan there are three Stock Exchanges: 1. Karachi Stock Exchange (KSE) 2. Lahore Stock Exchange (LSE) 3. Islamabad Stock Exchange (ISE)

1. Karachi Stock Exchange:

The Karachi Stock Exchange or KSE is a stock exchange located in Karachi, Sindh. Founded in1947, it is Pakistan's largest and oldest stock exchange, with many Pakistani as well as overseas listings. Its current premises are situated on Stock Exchange Road, in the heart of Karachi's Business District. Karachi Stock Exchange is the biggest and most liquid exchange and has been declared as the Best Performing Stock Market of the World for the year 2002. As on December 31, 2008, 653 companies were listed with the market capitalization of Rs.1,858,698.90 billion (US $ 23,527.83 billion) having listed capital of Rs. 750.48 billion (US $9.50 billion).KSE has been well into the 4th year of being one of the Best Performing Markets of the world as declared by the international magazine Business Week. Similarly the US newspaper, USA Today, termed Karachi Stock Exchange as one of the best performing bourses in the world.

2. Lahore Stock Exchange:

Lahore Stock Exchange (Guarantee) Limited is Pakistan's second largest stock exchange after the Karachi Stock Exchange. It is located Lahore, Pakistan. Lahore Stock Exchange was established in October 1970 and is the second largest stock exchange in the country with a market share of around 12-16% in terms of daily traded volumes. LSE has 519 companies, spanning 37 sectors of the economy, that are listed on the Exchange with total listed capital of Rs. 555.67 billion having market capitalization of around Rs. 3.64trillion. LSE has 152 members of whom 81 are corporate and 54 are individual members.

3. Islamabad Stock Exchange:

The Islamabad Stock Exchange (ISE) was incorporated as a guarantee limited Company on 25thOctober, 1989 in Islamabad Capital territory of Pakistan with the main object of setting up of a trading and settlement infrastructure, information system, skilled resources, accessibility and a fair and orderly market place that ranks with the best in the world. The purpose for establishment of the stock exchange in Islamabad was to cater to the needs of less developed areas of the northern part of Pakistan.

Capital Market Reforms:

Capital market reforms are aimed at a balanced development of the Pakistans capital markets and financial sector. These reforms assist in reducing systemic vulnerabilities in a bank-dominated financial system. Special emphasis is devoted to strengthen pension funds and other institutional investors, such as insurance, mutual funds, and non banking finance companies, given the strong causal relationship between the level of development of institutional investors and the deepening of capital markets. One of the major thrusts of reforms during the period remained on strengthening the governance of securities markets and market intermediaries to increase investors protection and confidence. New checks and balances have been introduced and systems have been put in place to control un-necessary Capital Markets speculation and systemic risk. These reforms have yielded dividends in the form of improvement in key financial performance and soundness indicators. Various capital market reform initiatives introduced by the SECP during the period under review are documented below:

Regulatory Reforms:
The reforms on the regulatory side include regulations governing Cash-Settled Futures (CSF) contracts, amendments in stock exchange listing, streamlining of the arbitration procedure and avoiding of any possible conflict of interest during the proceedings. New Risk Management Regulations for ISE have been approved. These regulations encompass VAR based margining system, new netting regime, imposition of position limits, mark-to-market loss collection regime, imposition of special margins and valuation of securities (haircuts regime).

Developmental Activities:
CFS Mk II, launched in April 2008, allow direct provision of finance in the equity market by institutions in the capacity of authorized financiers by committing a minimum amount for a period of at least 90 days. The Commission actively developed a Financial Institutions Margining System, which is a mechanism enabling collection of margins directly with National Clearing Company of Pakistan Limited (NCCPL) from nonmember institutions dealing through a member of the exchange. A shorter T+2 settlement cycle for trades on stock exchange, introduced in August 2007, facilitated to reduce the overall settlement risk in the market and brought the domestic markets at par with various international jurisdictions. To enhance transparency and effective monitoring of capital markets, the Commission initiated measures for compulsory reporting of all offmarket transactions at the stock exchanges and automated the process of handling corporate actions in CFS

transactions. The Commission has taken steps to enhance NCCPLs paid-up capital to Rs. 300 million and reduce stock exchanges share holding to 30% of the overall paid-up capital. SECP has acquired a surveillance system from a local IT solution provider to strengthen its stock market monitoring capacity. The system enables alerting on real time basis and facilitates detection of market manipulative activities.

Primary Market:
5th area required for the development of fixed income bond market is to have developed Primary Market in the country. Prerequisites for this area are: Sale of securities through auction in the first place. Sale of Securities on Syndication/Underwriting/Tap Sales/Private Placements as and where required. A time table with less frequent auctions and reason able volume for each auction. Announcement of Government borrowing requirements and borrowing calendar. Dissemination of auction data. Distribution through Primary Dealer system. Although some developed countries have set up system of Primary Dealers at some point in the development of their Government Securities market but several countries have succeeded without them. The development of electronic trading system and internet can play a useful role in the issuance and absorption of Government securities and over time can reduce the role of Primary Dealers in the Primary Dealership market. Obligations, privileges and eligibility criteria for Primary Dealers are very important and they are two way affairs. Developing Primary Market is a dynamic process that depends on a countrys initial condition and on the sequencing of reforms. In some countries like USA same financial institutions as Primary Dealers are used for monetary policy Operations; however two sets of Primary Dealers are possible. One can be used for issuer and other for Central Bank Operations. Pakistan started developing Government Bond market in 2000 by introducing Pakistan Investment Bonds and making their sale through selected Primary Dealers. Though first market based long term instrument (FIB) was issued in 1992 but they were allowed to be accessed by all the financial market players in the Primary Market, however with the discontinuation of this instrument in 1998 (Reason being that yield curve became inverted) it was felt that fresh efforts may be started by selecting financial institutions having expertise to deal in securities business. Now the system of PD has gone through an experience of six years. During this period Central Bank made changes in rules governing their rights and obligations and lately they have been made subject to performance criteria for their yearly evaluation. During last six years the system remained comprised of following institutions:

Financial Institution:
It is evident that Commercial banks have remained the main part of the PD system in Pakistan which ideally does not suit the system as a PD is required to raise its inventory for onward distribution whereas in case of banks they sometime go for their own inventory for their reserves requirements. This distorts the pricing in the market. However there is no other solution at the moment as brokerage houses/DFIs/Investment Banks ideally suited for the job have very weak equity base and hence can not be assigned the responsibility. The other issue is non existence of auction calendar for the issuance of long term instruments. Further the auctions announced in this respect most of the time represent small size issues that are not sufficient to create Bond Market liquidity.

Recommendations:
1. PD system be developed in gradual manner by involving potential non bank financial institutions to become part of PD system. 2. Government borrowing requirement/Calendar of auctions be announced annually.

Secondary Market:
6th area required for the development of fixed income bond market is to have well functioning Secondary Market in the Country. Prerequisites for this area are: Low transaction cost. Wide availability and continued pricing. Wide accessibility to trading system and intermediaries. Safe and rapid settlement of transactions. Effective custodial and safe keeping services. Use of Repo agreements. Well established derivatives market. No direct involvement in market structure to shift undue risk to Central Bank or Debt Management Office. Countries in the world have varied experience in developing secondary Market of the Securities. India and Malaysia developed discount Houses to increase trading volume and to establish bond market. Jamaica, Iceland, Thailand, Malaysia, Nepal have instituted Secondary Market window as transitional arrangement. Bank of England operated secondary market window for gilt edged indexed linked instruments to encourage the market. In Germany the Bunders bank of Germany participates in the market on 8 regional exchanges for

buying and selling securities to reduce price volatility in secondary market trading. In Poland the National Bank of Poland provides an inter-dealer brokerage system for Central Bank Bills and T-bills. In Pakistan the PDs are the main players of the secondary market as by regulations they have to be the price makers. During 2006 PDs share in PIB secondary market trading was 93.18% and in MTBs it was 77.39%. However, overall secondary market volume remained thin due to non supply of PIBs. The situation can only improve if GOP remains committed to keep consistent supply of the instrument. Secondly to improve secondary market trading of the bonds Central Bank needs to establish a bond trading desk at its Treasury for its market interventions.

Recommendations:
1. To promote Repo and Money Markets. 2. To promote prudent regulations governing trading practices. 3. To promote system of market makers. 4. To promote the emergence of inter-dealer brokerage and organized trading facilities. 5. To eliminate taxes impeding securities transactions. 6. To develop automated trading systems to encourage access by onshore and offshore investors (Connections to Euro clear, Bloomberg, Swift, Clear stream, CDC) 7. To evaluate alternatives for gradually introducing trading in derivative instruments as well as the preferred venue (Exchange or OTC). 8. To promote development of trading culture in the market through professional associations, Primary Dealers, entry of foreign institutions.

CORPORATE BOND:
A corporate bond is a bond issue by a corporation. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date. (The term "commercial paper" is sometimes used for instruments with a shorter maturity.) Sometimes, the term "corporate bonds" is used to include all bonds except those issued by governments in their own currencies. Strictly speaking, however, it only applies to those issued by corporations. The bonds of local authorities and supranational organizations do not fit in either category.[clarification needed] Corporate bonds are often listed on major exchanges (bonds there are called "listed" bonds) and ECNs, and the coupon (i.e. interest payment) is usually taxable. Sometimes this coupon can be zero with a high redemption value. However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in most developed markets takes place in decentralized, dealer-based, over-the-counter markets.

Liquidity of the Corporate Bond Market:

Availability of data on secondary market transactions plays an important role in making the price discovery process more efficient leading to improved liquidity. Much of the secondary market trading data is already available in Reuters and on the SBP website. This data dissemination process can be further strengthened by providing the data on a historical basis and in a readily usable form. The stock exchanges should make it mandatory for their members to report any debt securities transactions. In order to improve liquidity, SBP should consider introducing a repo facility for TFCs. The SBP could make a significant contribution to improving liquidity by accepting some high-grade TFCs as collateral for their lending operations. Repurchase transactions (\repos") do not elect bond prices directly so have less of an impact on the market, but play a role in adding liquidity to the market (Knight (2006)). The liquidity premium is likely to be reduced since the investors have an option to get cash at the current repo rates. \In the United Kingdom, there is evidence that the introduction of repo markets facilitated arbitrage along the securities yield curve, as rejected in a narrowing of the average gap between yields on outstanding securities and yield curves (Knight(2006))." Similarly, Mexico has also started a repo facility for corporate bonds.

CORPORATE DEBT SECURITIES:

During 1960s and early 1970s, before the nationalization of financial institutions in Pakistan, corporate debentures were issued by Pakistani companies. These securities were listed on stock exchanges in Pakistan. Debenture is a debt security bearing interest rate. In Pakistan Muslim population constitute the major part and dislike interest based lending and borrowing as it is against Islamic provisions of Sharia. In the month of June, 1980 the then government introduced an alternative mode to the debenture (being interest based security) through incorporating provisions in the legal Financial System as Participation Term Certificate and allowed corporations to issue interest free instruments for raising money for medium and long term and allow participation in the companies profit and loss as the case may be. Commercial Banks and Financial Institutions participated in companys profit and loss through their investment by purchasing PTCs. The investment through PTC took place where the company (borrower) had already invested its capital and was in the need of more funds to be invested in the project/ activity. The lender was provided security by companys tangible assets as collateral. Participation term certificate holders share profit and loss as per other shareholders of the company. They were entitled to have a share out of profit in case of profit earned by the company and if company sustains loss, it would be first covered out of companys reserves and then (if still left the amount of loss) will be borne by the PTC holders with other shareholders. Later on, in 1984 a provision was incorporated in companies ordinance 1984 under section (120) where the companies could issue Term Finance Certificate (TFC) by making public debt issue. Since 1995 Pakistani companies started issuing TFC which was different from the traditional corporate bond as it substituted the words expected profit for interest rate. The mechanism was set as, there is original price that the issuer receives in the 12 An Analysis of the Banks Write Offs 1999-2003 SBP Report20 beginning and there is repurchase price that the issuer pays at the time of maturity or in the years before the maturity. The difference was not fixed rather expected and floating based on PIBs, KIBOR or any other rate. TFC permitted through legislation in 1984 allowed the issuance of security as redeemable capital, but there was no TFC issued by private sector Pakistani companies during 1984 to 1995

period. As long as 1985, privately placed Term Finance Certificates (TFCs) issued by development finance institutions had been in existence. TFCs worth Rs4.57 billion were issued during 1995-2000 and worth Rs80.64 billion 2001-2008. TFCs issued by Pakistani companies since 1995 to 2008 are shown in Table 2.19 and2- 20 below. Total worth of TFCs as percentage of market capitalization is less than one percent.

MUNICIPAL BOND:
A municipal bond is a bond issued by local government, or their agencies. Potential issuers of municipal bonds includes cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and any other governmental entity (or group of governments) below the state level. Municipal bonds may be general obligations of the issuer or secured by specified revenues. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.

Municipal bond issuers:

Municipal bonds are issued by states, cities, and counties, (the municipal issuer) to raise funds. The methods and traces of issuing debt are governed by an extensive system of laws and regulations, which vary by state. Bonds bear interest at either a fixed or variable rate of interest, which can be subject to a cap known as the

maximum legal limit. If a bond measure is proposed in a local county election, a Tax Rate Statement may be provided to voters, detailing best estimates of the tax rate required to levy and fund the bond. The issuer of a municipal bond receives a cash payment at the time of issuance in exchange for a promise to repay the investors who provide the cash payment (the bond holder) over time. Repayment periods can be as short as a few months (although this is rare) to 20, 30, or 40 years, or even longer. The issuer typically uses proceeds from a bond sale to pay for capital projects or for other purposes it cannot or does not desire to pay for immediately with funds on hand. Tax regulations governing municipal bonds generally require all money raised by a bond sale to be spent on one-time capital projects within three to five years of issuance. Certain exceptions permit the issuance of bonds to fund other items, including ongoing operations and maintenance expenses, the purchase of single-family and multi-family mortgages, and the funding of student loans, among many other things. Because of the special tax-exempt status of most municipal bonds, investors usually accept lower interest payments than on other types of borrowing (assuming comparable risk). This makes the issuance of bonds an attractive source of financing to many municipal entities, as the borrowing rate available in the open market is frequently lower than what is available through other borrowing channels. Municipal bonds are one of several ways states, cities and counties can issue debt. Other mechanisms include certificates of participation and lease-buyback agreements. While these methods of borrowing differ in legal structure, they are similar to the municipal bonds described in this article.

Municipal bond holders:

Municipal bond holders may purchase bonds either directly from the issuer at the time of issuance (on the primary market), or from other bond holders at some time after issuance (on the secondary market). In exchange for an upfront investment of capital, the bond holder receives payments over time composed of interest on the invested principal, and a return of the invested principal itself (see bond). Repayment schedules differ with the type of bond issued. Municipal bonds typically pay interest semiannually. Shorter term bonds generally pay interest only until maturity; longer term bonds generally are amortized through annual principal payments. Longer and shorter term bonds are often combined together in a single issue that requires the issuer to make approximately level annual payments of interest and principal. Certain bonds, known as zero coupon or capital appreciation bonds, accrue interest until maturity at which time both interest and principal become due.

Equity Capital Market:

Pakistans stock market showed considerable resilience at the back of robust economic growth. However, key macroeconomic indicators exhibited Pakistan Economic Survey 2007-08 98 less than satisfactory performance as a result of rapid changes in the political landscape. A buoyant stock market can be attributed to the continuity of the macroeconomic policies of the government and capital market reforms implemented by the apex regulator, the Securities and Exchange Commission of Pakistan (SECP). Difficult global and domestic conditions adversely impacted foreign portfolio investment into the local equity market.

Foreign portfolio investment showed a net outflow of US$45 million during first nine months of the fiscal year 2007-08.

Corporate Debt Market Reforms:

The maximum initial listing fee for debt instruments has been reduced by KSE from Rs. 500,000 to Rs. 100,000 and the stamp duty on debentures and commercial papers has been reduced by Government of Punjab. The later is also under consideration of provincial governments and administration of Islamabad Capital Territory.