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Market Crash and Derisory Impromptu Regulatory Response
RASHAD HAQUE suggests ways to make investing in capital markets safer and more rewarding in the long run.
Photo: AMRAN HOSSAIN
I would like to start off on a positive note by saying that I think capital markets' growth as a whole has been great for Bangladesh and should be nurtured for continuous sustainable growth. In a country where banks charge double digit interest rates on any kinds of loans and there is no alternative funding source such as private equity or venture capital for enterprises to grow, capital markets is the only viable low cost option for them to raise capital to expand their businesses.
I started investing in Bangladesh stock market in a very small way starting in 2006 at the urging of my father-in-law (God rest his soul), a sponsor director and a founding member of one of the leading financial institutions in the country. Though he was an enthusiastic investor, the memory of crash 1996 taught him some painful lessons. The crash had the unfortunate consequence of requiring him to sell his sponsor directorship for another insurance firm he founded because at that time he was heavily investing through a margin account. My late father-in-law had taught me a lot about the share market in Bangladesh and its whimsical nature. While away in New York, I kept up with my investments and economic events in Bangladesh through scouring the daily news and following the market.
Having been a passive investor in a small way and watching things from a far, I outlined the following reasons for the market gyration while it was in motion, so it was good to see some of the recent policy responses address some of the points raised below. I believe the following played a major role in contributing to the crash:
Overenthusiastic investors: Unrealistic expectation of investors who for some reason or another seem to think the market would only go up (taking a longer term view -- in decades -- this is probably not completely off the mark when you take into account Bangladesh's growing economy, competitive positioning and progressive integration with the world market economy). Anecdotally, I can tell you that the share market had replaced politics (a good thing) as the main topic of conversation in Bangladesh. When I was in Bangladesh in August 2010, I had an enlightening chat with a driver of a financial institution on my way from the airport. He was bragging about how much money he had made in two weeks. When asked why he invested in the script he did, he said it was because it was going up and he'd heard from other people it was a good script. A good portion of the investments in Bangladesh stock exchange are trend-driven and unfortunately even rumour-driven.
SEC: Policy failure from Securities and Exchange Commission (SEC) to make any meaningful policy change that could have stopped the bubble when the market was moving up 3% + every week for months. It's not sustainable or even natural for markets to rise consistently on a daily basis as it has for the last nine months or so and we have seen what happens when it does. While I agree that there was some warning from the policy makers, they failed to take any concerted actions to impact the rise in any sustainable way. And when the SEC did take action, the regulators were flimsy in adhering to the policies, caving under pressure whenever there was protest as often happened when there was a 2% correction. This whimsical behaviour does not exactly lend to its credibility as a market regulator.
When an overdue market correction was finally underway, the constant policy change of SEC didn't help the fact; it added additional uncertainty to a market that was already volatile. If there is one thing markets hate more than negative news, its downbeat uncertainties. Had the “regulators” stayed away and not made drastic policy changes every other hour, things would have been more manageable.
Another policy mistake made by the regulators was stopping trading practically every day for a week. This is the last resort a regulator takes, yet they were doing it practically every day. Before taking such a hasty decision, one should ask what kind of confidence this instils in the market. Adding fuel to the fire, regulators supposedly put an index breaker in place yet it did not kick in when it was required. Had regulators want to resort to closing the market, they should have done things properly by closing the market for a week or so and let the "Bengali emotions" settle down a bit while also using the time properly as a stop gap measure. This time could also have been used to shore up any other support they wanted to implement in concerted efforts with the financial institutions as was finally done.
It was good to see the honourable finance minister intervene in concerted efforts with the business and banking communities. They did come up with some thoughtful policies but my view is that had the regulators stayed away from the start and let the market take its due course we would have been on better footing. I believe that as a result of the recent policy implementation, we have just postponed the inevitable correction. It will happen eventually whether gradually or abruptly, though the former is preferred.
Though unfortunate, at least now the incompetence of our regulators (particularly the SEC) and how little they know about how markets work is clear. I hope they have learned from this experience to let the market function as it should to eventually find its true value because the more you try to provide artificial support to an already overvalued market the longer you postpone and prolong the issue with market prices not reflecting its true value. By constant intervening, we eventually set ourselves up for a bigger crash down the line.
Recommendations for the SEC and BB
My first long-term recommendation for the SEC/our exchanges is to build a partnership with other developed exchanges in the region to become competent; much like the Bombay exchange has with Singapore Exchange. This will facilitate knowledge-sharing that can potentially be adapted to our exchange over time, whether it's surveillance programme or technology adaptation. Singapore Exchange is a premier bourse in the region that not only enjoys confidence of global investors and institutions all over but is also one of the most profitable.
My second recommendation for the SEC to review its policy on share dividends and rights share is to ensure that it does not add to instability of the market. I am pleading ignorance here as I could not find any documents to understand on what basis dividends bonus share and rights share are approved by SEC but my feeling is that it is a very arbitrary and non-transparent process. The arbitrary nature of this process not only opens it up for abuse and outside influence but also indirectly fuels some of the high P/E ratio we are witnessing in some of the sectors and companies right now.
Photo: RASHED SUMON
Let's analyse a hypothetical company based on the PE ratio of the sector listed. Let's say the company is a Ceramic Company called ABC Ceramic Ltd. It's doing well and every year the company's profit is growing. At the moment the share price is 870 Taka per share and its net income is 10 Taka per share. This gives you a P/E ratio of a whopping 87. While one may be inclined to think this is only fictional and does not happen in real life, just look at the above chart to see that this is the sector PE ratio of the ceramic sector as a whole. Conceptually you would think the SEC will not grant ABC Ceramic Ltd. an approval to issue more right share or bonus share dividends since P/E ratio is already very high and doing so might make the P/E ratio even higher; sadly, this may not be the case. So what happens if the SEC grants this company to offer right share on 1RS:1 Share held. While one hopes that price of this company would go down to adjust to new EPS, more often than not, the share prices have stayed close to its original price. If the price of the share is now only 700 Taka as opposed to before, the new PE ratio is now an incredible 140.
Bangladesh Bank: There has been initial view from the Bangladesh central bank that monetary and other policy should not consider the market during policy implementation; I believe this view is outdated. As capital markets become more mature, monetary policy and money supply in particular definitely impacts the market as supply finds itself to a rising market and other assets such as real estate in search for a higher return. Many observers, myself included, pointed to the central bank's swift directive to financial institutions to shore up its capital base at year end as another reason for adding extra pressure on the market. While I agree with this assessment, I believe it was the right one and overdue considering majority of the bank's exposure to the market. My observation is that the swiftness was due to Bangladesh Bank's (BB) original policy failure, which was failure to ensure strict adherence to the bank's directives regarding capital ratio requirements (% of money banks should have for the amount of deposits) and exposure to the capital markets (maximum amount banks are allowed to be exposed to the capital markets). A good number of financial institutions were flouting both of these rules. The capital ratio requirement was one of the reason intra bank money rate shot up to 190% when a good number of banks had shortfall when it was raised and had to go to market to cover at the same time making cash very dear. This meant that banks not only had to raise cash (potentially through selling their holding in stocks) but also had to restrict cash outflow (restrict margin loans) contributing to sizable correction at year end.
The policy response as it was laid out recently to separate banks' core banking activity (deposit and lending) from trading activity (banks' activity as it relates to capital market) was a good one in principle. However, the difficulty I see is in implementation. While in principle it should work, banks can easily flout the exposure limit, as they have done so before. As such, I think the stakes are higher for the central bank to monitor financial institutions' activities. Failure to monitor banks' exposure to the capital markets raises the risk of severely impacting the banking sector and potentially cripples the economy as a whole as a result of a major crash.
Further recommendations
While the decision of SEC and Central Bank to better coordinate policy implementation is a step in the right direction, I believe the risk is significant enough that the Central Bank itself should move swiftly to create a monitoring cell that proactively monitors financial institutions' exposure. The cell's primary responsibility may include the following:
--Actively monitor financial institutions' direct exposure to the stock market as a direct investor
--Actively monitor financial institutions' indirect exposure to the stock market (via margin portfolios)
--Constantly perform threshold and regression analysis on various financial institutions' capital market's activity to proactively direct them to take corrective measures
--Perform monthly risk/regression analysis of banking sector to take any corrective measures based on data supplied from financial institutions
--Coordination and implementation of policies with SEC that impact the markets
--Serve as a communication platform between SEC and the Central Bank
--Share intelligence between the two organisations
A close eye to alleviate any potential fallout from any major market gyration to ensure impact on the banking sector and economy as a whole is required and should not be a passive agenda of the central bank.
Financial institutions: It is no surprise that majority of the financial institutions have become heavily leveraged and exposed to markets both as direct investors, investing surplus capital and indirect exposure via margin loans to retail investors. If anyone happens to follow the Bangladesh banking environment as I “obsessively” do, you would know that just a year ago banks were complaining about unproductive “excess liquidity” in its balance sheet and even lowered the deposit rate as a result. I believe most of this “liquidity excess” and has found its way to the stock market. As I have discussed above about banks' capital and exposure to the market, I believe it's already been reported that there are a number of banks who have misaligned capital ratio. What that means is that technically these banks are undercapitalised, meaning that had a large percentage of depositors demanded their money back the banks would have had to go somewhere else to cover.
Media response: While I don't think the media was in any way responsible for the crash, it certainly added to the confusion at the time, adding to the hysteria. One hopes the media coverage of a major event such as the stock market crash would be informative but our media coverage on the subject was amateur at best. At times media stories came across as two shop keepers/friends indulging in gossip and rumours that were out there rather than actual substantive reporting that would disseminate information for readers to make up their own minds. While unintentional, I believe this is due to a dearth of knowledge and understanding of the subject matter. I hope media organisations will assess their reporters' skills in terms of financial reporting so that in future, coverage is more insightful for their audience.
So what does all this mean for us regular investors? Unfortunately, I think there will be more volatility and major corrections along the way.
Sustainable outlook -- investing for the long term
Market prices always reflect its true value longer term; despite the regulators' intervention the price should reflect a rational value at some point or another. It's good to keep that tenet in mind as a prospective investor. While in the above section I discussed the current state of affairs and potential regulatory pitfalls regarding the stock market, below I would like to focus more on what regular investors like you and I can do to navigate the market. Based on current conditions, it would not be irrational to expect a lot more volatility (up and down swings) in the marketplace, so I offer the following simple suggestions to navigate the market by investing for the long term.
* Avoid trading with margin: Because if there are big down swing and your account value drops under a certain percentage, the broker will require additional capital to bring your account in line with the money you borrowed, something called a margin call. If you fail to meet this extra fund requirement, the broker can start selling you shares to bring your account in line with margin percent. This is absolutely the worst time to sell because you have incurred so much loss. As I pointed out with my father-in-law who was trading on margin, a margin can make you lose your prize possessions when you have to scramble for cash.
* Invest money you can do without: Invest some of your extra capital that you can do without long term (say for five years or more) and not your life savings or money that you would need in the next few months or in case of emergency.
* Invest in good companies: Invest in stocks with Llw PE Ratio (you can find this by dividing the price of current share by current earning). Be careful not to just look at the most recent earning, look at the earnings and PE ratio of the company over three to five years. One does not have to research all the companies listed in Dhaka Stock Exchange to find good companies. Start researching companies you know and buy things from regularly (Example: food, water, electricity, household goods, shoes and clothes, electronics, gas, etc.)
* Invest for the long term and sleep easy: Invest for the longer term (minimum five years) in companies that pay good dividend. If you invest in good dividend paying companies, chances are that you will accumulate more shares because the company pays good bonus share or you will make small extra income through cash dividend. While you want to track the performances of your investment from time to time, remember you are invested for the long term so don't obsessively check how the share price is increasing 10 Taka here and losing 5 Taka there.
* Do not trade on rumours: While it's fine to take suggestions from people you know and do your own research before investing, do not just buy a script based on what others tell you. Unfortunately, a lot of new small investors are sucked into this by friends, family members, associates or colleagues. There is a certain section of investors that spreads unfounded rumours after taking large positions on certain stocks. When the rumours spread and a buying frenzy begins, they slowly exit their position in profit. As with any developing market, I think this will continue for some time until SEC becomes sophisticated and competent enough to monitor this. I would hope staff at SEC get training from regulators from developed international markets such as UK, US or even from savvy regulators in countries such as Singapore to improve their competence.
To leave off on another positive note, long term (think in decades), I believe the future of the stock markets and Bangladesh as a whole is an encouraging one if a conducive, accountable and sustainable environment is created for enterprises to grow. Along the way, I hope there will be much needed changes for the better in infrastructure development, electricity generation, government accountability and lessening corruption.
Rashad Haque works as a management consultant serving the financial services industry in New York. He can be reached at Rashad.Haque@gmail.com or http://www.linkedin.com/in/rashadhaque.