By Bruno Carrasco and Syed Ali-Mumtaz H. Shah
Bangladesh has had its share of stock market booms and busts. Following a bull run during most of 2010, the Dhaka Stock Exchange (DSE) crashed in early December 2010 and by March 2011 the index had fallen by half from its all-time high.
The market correction wiped out US $27 billion in market capitalization and with it bankruptcies, savings, and jobs, triggering a wave of social discontent. The ensuing liquidity crunch led to heightened solvency risks. Indeed, given the interconnectedness between banks and equity markets, there was a grave concern that a perfect storm could result in a negative feedback loop from the financial sector to the real economy and potentially bringing the economy to a grinding halt.
The 2010 crisis was a case of deja vu and brought back memories of 1996 when kerb trading led to another large sell-off and brought the economy to the brink of a financial meltdown.
The encouraging news is that this time around the authorities did not let a crisis go to waste.
A high-level probe was established to examine the deficiencies that led to the crash. As part of the probe’s findings, important lessons were identified, which have placed financial markets in a much stronger position. To begin with, policy-makers recognized that capital markets have played a limited role in supporting the development of the economy and that this had to change.
If Bangladesh is to increase its Gross domestic product (GDP) growth and attain its annual target of 10 percent growth by fiscal year (FY) 2021, the government was cognizant that it had to address structural deficiencies in the capital markets by deregulating the financial system to promote private sector investment and better support the real economy.
In addition, it recognized that given the changes taking place across financial markets, the regulatory bodies and other supporting institutions had to be given the necessary resources to ensure market development and stability. Finally, it recognized that given the inherent interconnectedness of financial markets, coordinated supervision was critical to avoid regulatory arbitrage and with it increasing distortions in the economy.
The government therefore embarked on a programme of meaningful reforms and partnered by the Asian Development Bank (ADB) under the Second Capital Markets Development Programme (CMDP2) in November 2012.
The programme is based on a two-track approach that seeks to put fire walls in place to support market stabilization and plant the seeds for key reforms that would lead to sustainable market development.
CMDP2 is based on three important pillars. First, the Bangladesh Securities and Exchange Commission (BSEC) had to be given a stronger mandate, together with resources. The amendment of the Securities and Exchange Commission (SEC) Act in November 2012 paved the way for the BSEC to have unhindered access to the BSEC Fund. The amendment also removes government approval of the BSEC budget or expenditures from the BSEC Fund as well as provides benefits to BSEC staff comparable to those at Bangladesh Bank (BB).
The operationalisation of a real-time market surveillance system under CMDP2 is helping BSEC to detect trading irregularities and market abuse as they occur. The installation of such a state-of-the-art surveillance system will increase transparency of market transactions and contribute significantly to enhanced investor confidence.
Critical drivers of change
Secondly, stock exchanges were identified as critical drivers of change. The agreed approach was to correct the governance structure through demutualization of the Dhaka and Chittagong stock exchanges. This would serve to align the broader incentives of market development with those of the “club members,” mainly the brokers and dealers. Numerous steps have been taken to effectively implement the demutualization process, such as enactment of the Demutualization Act in April 2013, followed by submission of the demutualization schemes by both stock exchanges and the approval of these schemes by BSEC in September 2013. Finally, bond markets had to be promoted to mobilize much-needed long term financing. This would serve to address the major development challenge, namely how to finance the looming infrastructure gap in the economy.
To develop a more liquid bond market and reliable yield curve, CMDP2 is supporting the development of an efficient primary dealer system through the fostering of a more competitive auction system. This is expected to support an improved price discovery process of treasury bills and bonds in line with the state of demand for these securities. CMDP2 also supports the corporate bond market by implementing a fast-track BSEC regulatory process for private placements that balances investor protection with the ease of approval. Removal of tax distortions were also introduced in the June 2013 budget to trigger bond market activity and catalyze asset-backed securities, such as the elimination of transaction taxes for bonds and stamp duty relief on the transfer of assets and taxes on income passed through a special purpose vehicle.
The CMDP2 is nearing its mid-point. Reforms have been rolled out and the market is gaining greater confidence in line with increasing traction of the new policy and regulatory incentives. Results to date are promising as foremost the market has stabilized as evidenced by the 21% increase in market capitalization to $32.98 billion (as of November 06, 2013) from $27.1 billion a year earlier.
With regard to valuation, the average Dhaka Stock Exchange(DSE) Price-Earning (P/E) ratio was at 11.85 in October 2013, which is certainly more attractive from an investor’s perspective than the average P/E ratio of 30.6 at its recent peak in February 2010.
Net foreign portfolio investment has witnessed consistent gains since early 2012, indicative of market recovery and attracted by the prevailing stock price valuations. The turnover ratios in 2013 are comparable with the levels recorded during 2004-6 at a time when the market was functioning in a stable environment. The DSE average daily turnover as a percentage of market capitalization from January 2013-October 2013 was 0.16 percent as compared to a high of 0.73 percent on December 06, 2010.
It is important to note that these reforms are not piecemeal but form part of a comprehensive long-term national capital market master-plan approved by the government. The master plan sets the direction to transition from a nascent to an emerging capital market.
The implementation of reform measures elucidated in the master plan is necessary to place Bangladesh’s capital markets on a path to sustainable growth. Critical reforms that are currently in the process of being approved and implemented include the establishment of the Capital Market Tribunal and enactment of the Financial Reporting Act (FRA).
The enforcement capacity by BSEC will be significantly enhanced through the creation of a capital market tribunal, which would expedite resolution of securities cases pending in the court system in Bangladesh.
Approximately 366 BSEC cases are pending with various courts, which include 15 cases brought as a result of the stock market crisis of 1996. The enactment of the FRA will play an integral role in upgrading the accounting and auditing standards to enhance market confidence.
The enactment would be followed by the establishment of an independent Financial Reporting Council (FRC) that would adopt International Accounting Standards and International Standards of Auditing for the concerned entities, as well as to monitor and enforce them, and possess the authority to license auditors and accountants. Implementation of these pending critical reforms will lead to the successful completion of CMDP2.
There is increasing consensus that, over the longer term, capital markets will require further strengthening to better mobilize savings and efficiently allocate these in the economy. As typically witnessed across reform programmes, vested interests have been trying to preserve the status quo.
However, the financial sector authorities are proving to be a formidable force. They have understood that reforms will provide a win-win situation by strengthening the financial system to better support the real economy while enhancing the ability of responsible institutions to effectively carry out their mandates.
The ADB will continue to provide its full support towards ensuring a smooth transition in the development of the capital market reform process in Bangladesh as per the capital market master plan.
We look forward to continuing to partner with the authorities in the deepening of reforms under CMDP3 in 2015 by broadening the investor base and expanding market development measures introduced under CMDP2.
(Bruno Carrasco and Syed Ali-Mumtaz H. Shah work in the South Asia Department of the Asian Development Bank)