A Critical View of Recent Capital Market Crisis in Bangladesh

by Mizanur Rahman* 1. What is the cause of persistent crisis in the stock market in Bangladesh? Bangladesh capital markets experienced an unsustainable bubble in December 2010 and its bust was only inevitable. Many shares were then overvalued. Most of the IPOs and right issues in the pre-crisis time were also overvalued by several times of their fundamental values. A herd behavior ensued; a large number of small investors poured their savings into the share market. Demand for shares continued to shift rightward and price spiraling followed. The bubble quickly turned out to be unsustainable. It happened as Bangladesh Bank pursued contractionary monetary policy in December 2010. As the central bank continued contractionary monetary policy since then, interest rate increased and liquidity crisis deepened in the banking sector. Investors of all types faced soaring borrowing costs, demand for investment in shares plummeted. Daily turnover of the Dhaka Stock Exchange (DSE) declined from about 3000 crore Taka in December 2010 to below 100 crore Taka in July 2012. Investors confidence has declined and remained very low. The following factors led to this outcome of depressed pricing and a persistent crisis in the stock market: a. A monetary contraction and so the rising borrowing costs caused investors to deleverage. As the liquidity crisis further deepened in the financial sector, investors ability to borrow and invest in shares rapidly declined and remained constrained. b. Many investors who had invested in shares in pre-crisis time got trapped. Market value of their investment has decreased to one-third to one-fourth of the cost of the investment. Their investment thus tuned out to be largely illiquid. The ability of the merchant banks and brokerage houses to create fresh loans rapidly decreased. c. A large number of investors lost their equity or incurred negative equity. Many of them even stopped trading in their accounts. d. Direct investment by banks and other financial institutions in stock markets has rapidly decreased in the aftermath of the crisis. Several regulatory changes notably including limiting defacto exposure of banks to capital market, debasing of exposure from total liabilities to equities, and redefining singe exposure limit seriously constrained the financial sector to supply credit to investors. Demand for shares and so their prices kept falling. e. A series of unfavorable developments eroded investors confidence and their undue pessimism further deepened. Investors do not yet invest for fear of further losses. Any effort to recover turnover and so share prices is yet to prove effective. 2. What is the reason of the liquidity crisis? There are two main reasons of the continued liquidity crisis. One is that the growth of nominal money supply has itself decreased as the central bank sustained its contractionary monetary policy and the other is that the general price level (as measured by the consumer price index) rapidly increased since FY2008-9. When the general price level rapidly rises with a slower growth in nominal money supply, real money balance may even decrease. A gap between demand and supply of real money balance thus emerges, interest rate rises. In times of contractionary monetary policy, rising price level does always contribute to liquidity crisis in the financial sector. In the case of Bangladesh, this is just valid. To worsen the situation, indirect capital flight has likely taken place in the form of over-invoicing of imports or under-invoicing of experts or though hundi and other unlawful mechanisms. It has also contributed to liquidity shortages in the total financial system. 3. Government introduced several incentives to stabilize share markets in recent times. But no significant impacts are observed. Why? There is no quick fix to this problem. The incentive measures that the government announced for stabilizing the stock markets are not well coordinated. They are taken on an ad-hoc basis and in response to mounting public
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Dr. Mizanur Rahman is a researcher in accounting and economics and an associate professor in the Department of Accounting & Information Systems, University of Dhaka. E-mail: mizan@univdhaka.edu, Tel: +88 01817 684202, Fax: +88 02 8615583.

pressure. That did not restore investors confidence. The important reform which was needed is yet to happen. It is the restructuring of the Securities and Exchange Commission (SEC) with skilled human capital. SEC largely failed to this end. Both the SEC and the stock exchanges failed to monitor the issue of IPO and right shares. Overpricing through overstating EPS and/or NAV is still a problem. Non-compliance by the listed companies with mandatory disclosure requirements is pervasive. Audit opinion is not often reliable. Neither SEC nor the stock exchanges do yet have the capacity to achieve this end. The Inquiry Committee headed by Khondkar Ibrahim Khaled identified serious anomalies in the application of book building method and in the allocation of placement shares. In 2009 and since then many IPOs were over-valued and the SEC approval process was often opaque. The continued bearish trend of stock markets today is largely an outcome of the regulatory failure. 4. Why is the role of institutional investors like the nave general investors? Institutional investors are also investors and their behavior will likely to be profit maximizing. I find their behavior not much irrational. Given the lack of confidence and some adverse developments in the macroeconomic context, institutional investors would unlikely come forward to invest significantly in the capital markets. To see it happen, regulatory developments are imperative. 5. Merchant banks are in deep trouble as they extended margin loans to investors. How do they overcome this? SEC, merchant banks and investors are all responsible for this mess. On the one hand, SEC did not allow merchant banks to make forced-selling when share prices began falling. SEC perhaps did it in order to save the market from a free-falling. On the other hand, many investors did not sell their positions, repay their margin loans and exit the market with some equity, if any. They did it assuming that market prices were not overvalued. An outcome is that both the merchant banks and investors are now holding investments with deep losses. To recover from this crisis, turnover should increase to a reasonable level. Prices would then recover to their fundamental values and capital market be stabilized. It is possibly true that many shares are now traded below their fundamentals values. However, any sustained recovery would follow credible policy reforms at both the SEC and stock exchange levels. An effective demutualization of stock exchanges will be a step to this end. It will take time though. 6. What is the main reason that our capital markets do not attract foreign investors? The main reason is de-facto capital control that exists in the foreign exchange market. Moreover, foreign investment in securities denominated by Taka will essentially accompany foreign exchange translation loss that will arise from persistent taka devaluation against the US dollar and other major foreign currencies. Given that our capital markets are quite narrow (as defined by turnover relative to GDP) and volatility is large, foreign investors would find it risky to invest in securities listed in our stock exchanges. 7. What is your comment on the present SEC? How do you evaluate their activities in the last one year? SEC is expected to ensure prudential regulation of capital markets in Bangladesh. To do so, SEC requires many technical and analytical skills. They include (a) validation of offer prices of the IPOs, RPOs and other equity offerings; (b) an effective monitoring of insider trading and control of market manipulations through robust surveillance mechanisms; (c) ensuring compliance with financial disclosure requirements; (d) assessment of the audit opinion and quality of financial disclosure by the listed companies. SEC is not functioning effectively to these ends because the regulator has a serious lack of technical and analytical capability. SEC pursued a number of reforms in recent times to be implemented in short-to-medium-to-long term. One major reform is the requirement that sponsors shareholders shall individually hold a minimum 2 % and jointly hold a minimum 30 % of the issued and paid-up capital. A failure to meet this requirement led to 359 casual vacancies in the board of directors of 102 companies. This policy is questionable. As the facts indicate, incorporation of new directors in the board did not happen as it was expected. It is likely that many past directors will continue to remain in the board through different means. Many other measures of SEC also appear to be ad hoc. For example, settlement period is still T+3 and it is impeding investors to arbitrage properly. Transaction cost seems too large due to this long settle period. SEC also failed to bring about a significant change in the corporate governance. A major objective of the new SEC was to raise investors confidence and increase turnover in the market. That did not happen as intended. It is mainly because SEC could not identify and investigate many irregularities that happened in the process of the stock market bubble. Furthermore, a problem of policy inconsistency is common. For

example, a recent SEC declaration that new IPOs would be allowed only if they are offered at face values or with low premium is contrary to fundamentals of finance. The offer price of an IPO should depend on its earnings per share (EPS), growth in EPS and the net asset value (NAV) per share. IPOs at face values can be overvalued and IPOs with just premium can be fair valued. So the ultimate question is whether the EPS and other financial data as approved by auditors, stock exchanges, and SEC are true and fair. That capability is ironically missing. The end result is that investors confidence continues to be very low. 8. How do you think the mutual funds to play their role in the present context? Fund managers appear to be as nave as small investors. A large number of funds incurred substantial losses in their investment in securities. Their net asset values (NAVs) based on market prices remained far below the costbased NAVs for a long time. That was unusual. Again, a recent surge in the observed prices of some mutual funds is indicative of market manipulation. A finding that mutual funds incurred deep losses in recent turmoil indicates a disappointing scenario of mutual fund management in Bangladesh. Fund managers failed to appreciate widening gap between fundamental values and observed market prices of securities. In the present circumstances, they are unlikely to be able to inject any fresh liquidity into the capital markets. Fund managers need to improve their art of portfolio management by balancing between risk and return. 9. What factors should investors consider while investing in the capital market? Investors in general exhibit irrational exuberance in times of stock market bubble and undue pessimism after the bust of the bubble. Both behavioral patterns cause stock prices to deviate from their fundamental values. Investors are thus tempted to speculate with future EPSs and NAVs. And they often overestimate the variables particularly when stock prices keep rising. It causes overvaluation of many shares. To avoid this kind of behavior investors should assess long run profitability of companies. If they observe a sudden jump in EPSs, investors must identify reasons of the jump and evaluate its long-run sustainability. It is often observed that management in times of rising prices overstates earnings and NAVs and balance sheet thus becomes bloated with accruals. The EPSs and NAVs are thus not always a good guide. Investors should therefore examine earnings persistency, not just the one period ahead forecast of EPSs. 10. Why does everyone want to maximize short-term returns? Profit maximization in the long run is not necessarily conflicting with the goal of profit maximization in the shortrun. Problem arises only when do investors become either irrationally optimistic or unduly pessimistic. But this is human psychology as indicated above. Prudential regulation is needed so that investors are not tempted into herd behavior. SEC can formulate laws so that investors can obtain financial analyst services and make informed investment decisions. Stock exchanges can also educate investors as to help them make prudent investment decisions. They can organize training programs on technical and fundamental analysis of securities. Press and electronic media can also play a great role to this end. 11. What steps are needed to motivate institutional investors to be more active in the share market? Institutional investors will be active in the market only after cost of borrowing subsides in the money market. It would essentially require that money market is stabilized and interest rate declines to a reasonable level. That would require that inflation declines to a reasonable level. An effective resolution of margin loans that were extended to small investors and then turned out to be uncollectible would also help merchant banks and other institutional investors to inject new liquidity into the market. A policy of measuring capital market exposure by the banks and NBFIs in terms of their paid-up capital instead of total liabilities is too limiting. The policy shift was sudden and became too constraining to increase their implicit exposure in the capital markets to some reasonable level. The policy of single exposure limit does also require to be reevaluated.

12. There are allegations of inappropriate use of funds raised by issuing shares and securities by many companies. What do you think of it? It is true that some companies did not duly comply with rules and regulations in the process of raising capital through IPOs, convertible preferred stocks and debentures, and right issues. They are likely to have diverted the funds from their intended use and did not employ the funds for increasing productive potential of the firms. This

failing happened for various reasons. First, the role of auditor and audit opinion as to the financial statements of the companies are de facto unregulated. Note that overpricing of IPOs in many cases occurred only after auditors certified either overstated EPS or overstated NAVs or both. Neither SEC nor the stock exchanges did effectively monitor the role of auditors to this end. Second, a few companies raised funds from the capital market by issuing convertible bond and preferred stock. The process was opaque and overpricing happened during their conversion into common stock. SEC failed to monitor that the companies often used the funds to liquidate unsustainable debt and thus to restructure capital structure. It does not enlarge operating asset base. The imperative was that funds raised through the issue of common stock would contribute to enhance operating asset base of the company. Finally, the diversion of fund to illegal or unintended purposes happened largely because of weak corporate governance in the country and through illegitimate means. This area of reform is at its dismal stage and requires urgent policy interventions. These failings jointly led to the stock market bubble and then to its bust. An outcome is that a large scale redistribution of wealth happened from the poor to the rich. #END#