Revamping Nepali Bourse

Uncertainties about the country’s political environment notwithstanding, the Nepali stock market is showing firm confidence about the future of the country’s economy, making this the right time to hasten the reforms in the stock market.

And that is exactly what is happening, say the major regulators of the market. For example, Deepak Raj Kafle, Chariman of the Security Board of Nepal (SEBON), the supreme regulatory authority of the country’s securities market, claims that activities are underway to increase the depth of the market to extend its physical infrastructure and automation.

Similarly, Rewat Bahadur Karki, the General Manager of Nepal Stock Exchange Ltd. (Nepse), the company that operates the only bourse of the country, informs that the open-outcry system existing in the Nepse trading floor will be replaced by April this year when the ongoing floor automation project will be completed. Also on the cards is an over-the-counter (OTC) market for securities not listed on the stock exchange. That is not all. Nepse also has a plan to start trading on derivatives as well.

Current Situation

The stock market has expanded substantially in terms of both the market index and market capitalization. Though the all-inclusive Nepse index has not crossed the high of 547 reached in the fiscal year 2000-01, it was ruling at around 520-530 in the first three weeks of February 2007. Compare that with the 308 recorded on February 3, 2006 and that gives over a 200 point increase during a single year. The market analysts like to call it the “third bull run” in Nepse’s 12 year history. The challenge now is to sustain this positive outlook and avoid the prolonged downturn that followed both of the previous bull runs. Another positive point this time is that market liquidity has increased which means the risk of the stocks not being traded are getting less.

More important than that is the information that the market has been attracting more investors and they have started to be more calculative. Investors would not bother about the annual balance sheet of the companies till some months ago, but now they are asking for the latest situation and expert analysis. According to Karki, it is because more and more educated people, such as university teachers of finance, are coming into the market as investors. “Since these people analyze the market before making any investment decision, other ordinary investors too have started doing the same,” he adds. Nabaraj Pokhrel, the president of Nepal Stock Brokers Association, is hopeful about the sustainability of the current positive trend provided that the ongoing reforms in the regulatory regime and infrastructure development are speeded up to make the market more transparent and self-regulating.

The Needs

While it is good to note that the market index and market capitalization are growing, almost 70 percent of the shares in the market are not available for trading as they are owned by the promoters of companies and the rules restrict trading of such shares. This has limited the size of the market. Moreover, also increased is the market volatility as measured by the rolling 12-month standard deviation of the market index. This indicates that the risk of share prices going up or down is increasing (see a separate article by Dr. Bijay KC in this section about the analysis of market indicators).

According to experts, this requires a number of reforms and the major focus of such reforms has to be to increase the market size as well as the quality. This requires more players in the market who can provide expert guidance to the investors. This seems to be similar to the “chicken and egg” dilemma. While the expansion in the size of the market will require an increase in the number of players, the market volume itself has to grow first to attract more players in it. “But we can’t dismiss that simply as a chicken-and-egg situation. We’ve to take the initiative. So we are expanding the market as well as encouraging more players to enter it.” says Kafle.

One important reason why the previous bull runs could not be sustained was that the market then was in weak hands, says Pokhrel. “The market makers of that time could not analyse the market properly, they had low capital bases and most importantly, the rules were such that they could not buy sufficient number of shares in the Initial Public Offerings (IPO). But all these are changing now,” he says. According to him, non-resident Nepalis are showing interest to enter as institutional investors in the Nepali stock market. “They are mooting a mutual fund for this,” he says.

According to the expectations of the market analysts, the Army Welfare Fund and Employees’ Provident Fund too are showing interest in entering the stock market as the new rules being developed by SEBON have provisions to facilitate their entry. Moreover, the proposed rules allow banks and finance companies to play in the stock market through a subsidiary. Some banks are reportedly developing mutual fund schemes. With this, the observers expect that there will be market makers, dealers, investment advisors, mutual fund operators, etc. in the market which has only brokers at present. Recently, National Investment and Capital Market Ltd. (NICM) was set up with some prominent businessmen as promoters to function as a Full Service House to play all of these roles. Similar other institutions are expected to crop up very soon.

Meanwhile, NEPSE is also working on a plan to increase the number of brokers. At present there are 23 brokers, down from over 32 a few years ago.

Another need in the Nepali stock market reform plan is to privatize the stock exchange. Elsewhere, the stock market is an organization of brokers owned and managed by the brokers themselves. But in Nepal its majority shares are owned by the government. Therefore, the brokers are demanding that their organization should be allowed more say in the management of the exchange. Right now, the association of brokers sends two representatives to the Board of Directors of the stock exchange company. Pokhrel says the new rules seem to be too restrictive in the name of regulating the market and suggests the brokers be allowed to self-regulate it. “Since the brokers have a higher stake in the market, they will be the ones to suffer the most if the market goes down. Therefore, there is better incentive for the brokers to regulate the market than for the officials of the stock exchange or SEBON,” he says and adds: “Right now, the situation is such that though the brokers are members of the stock exchange, they are still outsiders.”

Infrastructure

Recently, Nepse has started its floor automation project which is expected to be complete by April this year, according to Karki. The brokers are not satisfied with this as it is a partial automation and they are demanding full-fledged automation of the entire process such that even clearing and settlement will be automated. According to Karki, that should not be a big problem. “This floor automation is to be based on Local Area Network (LAN). If the brokers use Wide Area Network (WAN), they can conduct the transactions from their office also. Moreover, if the Stock Exchange gets VSAT, which is in the plan, it can be provided to the brokers as well and, with this, they can provide service to investors outside Kathmandu also,” he says though he does not give a specific date as to when the stock exchange is planning to get the VSAT. Given the fact that the Nepse floor is already small for the 23 broker firms, the next step has to be to go for the whole process’ automation so that the brokers can transact the entire business from their office itself without going to the floor. “If full-fledged automation is introduced, there will be no need to expand the existing floor size. The saving from not expanding the floor size should be used for full automation,” says Pokhrel.

Another infrastructure that needs to be added in the stock exchange is a Central Depository System (CDS), but Karki says this is not in the present plan. “However, the next step will surely be to install the CDS,” he adds.

Other Recent steps

No of listed Cos
	Mid	Mid	Mid	Mid
	July 04	July 05	July 06	Dec 07
Commercial Banks	11	14	15	15
Manufacturing & Processing	29	29	29	29
Hotel companies	4	4	4	4
Other companies	4	5	6	4
Trading companies	8	8	8	8
Insurance companies	13	14	15	15
Finance companies	41	44	49	52
Development banks	4	7	8	12
Total	114	125	134	139
Out of the 20 companies newly listed in 2005 and 2006 in the stock exchange, 18 were from the banking, finance and insurance sectors.

After the massive decline in the share prices and the Nepse index following some changes announced in the monetary policy by the Central Bank in July 2006, Nepse has taken a number of steps aimed at market stability. For example, matching transactions (some brokers functioning on behalf of both the seller and buyer of a company’s shares) are prohibited so that the power of the brokers to manipulate the prices of shares in the market is curtailed. However, some sort of matching is said to still be in practice as some brokers are colluding to match transactions. One of them acts from the seller’s side and the other acts from the buyers’ side. However, this step of Nepse has reduced the majority of the problem, it is believed. Now, according to Karki, Nepse is scrutinising if there is circular trading, a name given to the phenomenon when a group of closely related persons trade among themselves and influence the price of a particular share.

Another development is that Nepse has started using the circuit breaker system more frequently to make sure that the transactions are not merely rumour driven. After the trading on a particular stock is halted by applying the circuit breaker, Nepse asks the company to disclose the material information, if any, that might have driven the price of the shares substantially up or down. Trading is allowed to resume immediately after such information is received by Nepse and revealed to the investors. But questions are raised on the logic of this circuit breaker system because, as the critics say, halting transactions like those is not compatible with the spirit of the free market (the suggestion is to rather enforce better disclosure requirements). However Karki believes that the circuit breaker system has negated the possibility of market failures of the type that was experienced a few years ago.

Nepse has also started calculating a sensitive index for the shares of the companies classified by it as category A. Though there are critics who question the existing methodology of selecting companies to be placed in category A, the new index is believed to be an improvement as it provides one more benchmark against which to compare the price of the stocks. Meanwhile, Nepse is also publishing a sectoral index of the banking companies every day. Investors feel that a daily index should be published also for other sectors so that the investors would have another benchmark index as well.

Also planned is an over-the-counter (OTC) market for the non-listed and delisted companies. But Pokhrel is not supportive of this idea because this may provide a pretext to the companies to not be listed. Nonetheless Nepse is planning to set up such a market as the new securities law has provided for some facilities to the non-listed and delisted companies. Pokhrel’s suggestion is to rather provide additional incentive, such a rebate on corporate tax, for the companies that get listed in the stock exchange.

According to Karki, Nepse has also approached the Central Bank to review its policy that allows commercial banks and financial institutions to issue loan against the security of share certificates. Under this system known as “margin lending”, the banks provide loan against the security of share certificates of actively traded companies up to certain percent of the current market price of the share concerned. This is said to be one of the reasons for the fast rise in the prices of some companies’ shares as this has increased the demand while the supply has remained the same. Moreover, some individuals who have influential holding in such companies have an incentive to artificially jack up the price of such companies’ shares. While, these points justify the logic to restrict margin lending, it is also pointed out that this system has provided a valuable service as it has helped to expand the market.

One very important feature of the Nepali stock market is that the shares traded belong mainly to the banking sector companies followed by finance companies, development banks and insurance companies. The trading in the shares of companies belonging to other groups such as manufacturing is very negligible. Such high concentration of the market in only one sector is regarded to be very bad.

Analysts say the main reason for this is the relative transparency of the financial services sector companies. For example, banks are required to make public their financial position every three months while finance companies are required to do so every six months. But the manufacturing companies are not required to do so. Therefore, the investors have to rely on insider information and annual reports which are brought out months after the completion of the fiscal year. Naturally, the investors are attracted to more transparent companies from which they get the information more frequently. Among the manufacturing sector companies, only those which are managed professionally (for example, those that are under joint ventures with multinationals) bring out the annual report within a month or two of the completion of the fiscal year.

Therefore, one suggestion to improve the market is to bring out a rule to force the companies in other categories such as manufacturing to make regular disclosures like the financial services companies. Kafle says the new regulations being finalised will have provisions to bring about uniformity in disclosure requirements for all companies.

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Investing on Stocks Some Tips to Success

by Nabaraj Pokhrel

People usually ask me about stock market predictions. Obviously, this is due to the frequent ups and downs in the market within so short periods as a week or even a day.

I have been observing these ups and downs for the last 12 years. And my learning can be summarised in the old proverb: "To reach the peak, one has to start from the bottom". The bottom can be rocky and the climb slippery. Sometimes, there may be sudden downslides after one has reached an attractive height. This means Investing in stocks is risky.

However, there are various tools to analyse and evaluate stocks. These tools make it possible to predict the market though a 100 per cent accurate prediction is not possible. The fundamental analysis of the stock market is based upon historical financial data which can give some clues to the future. But there are other environmental factors or variables as well to be considered, such as political, socio-economical or corporate fundamentals. These too influence an investor's willingness to invest and therefore influence the market's demand and supply mechanism. This can ultimately make predictions difficult even for the pundits. Thus, sometimes the investment made in the stock market becomes a mere speculation similar to gambling.

Suggestions

One should analyse and develop various alternatives to anticipate the best returns before making a decision. That, however, is not enough. Investors have to use their own common sense to make a right decision. Considering the risks, investors also need to be gutsy while investing in stocks -- starting the journey somehow and learning the tricks along the way. It is commonly known that profit and loss are part of the game. There may be some monetary loss in the beginning, but investors should not worry as they learn lessons in this way which can prove to be an asset in the long run. Start by playing safe and along the journey, be patient and try to develop a proper understanding of market language, investor's psychology, and market behaviour.

(Pokhrel is President of Nepal Stock Brokers Association)

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"Companies with good corporate governance will find it easier"

Deepak Raj Kafle
Chairman, Securities Board of Nepal (SEBON)

How do you evaluate the overall situation of the securities market?

We have a small market which is dominated by the scrip of banks and financial institutions. Historically, it has undergone three cycles of ups and downs but it is growing at present. Both the market index and market capitalisation have increased. We have to now go in for qualitative improvement. The market has to be further expanded and deepened. The number of stocks traded should increase so that small transactions will not affect the market. Similarly, the market infrastructure has to be improved and automated. There are improvements being made on those lines.

What steps are you taking to make the non-banking companies follow the regular disclosure practices as followed by the banking companies?

We are certainly doing this. The Securities Law was recently promulgated to replace the Securities Ordinance. The companies that go for initial public offering (IPO) under this law will have to make material disclosures to the public. In the past, companies had to disclose the information in the prospectus in accordance with the Company Law but now they will have to follow different regulations under the new law. We are trying to bring uniformity to the disclosure practices of all the companies. Thus, they will all be required to publish their quarterly financial reports as banks do. In addition, the Board will review these reports and if any discrepancies are seen in them, it will ask the companies to make the necessary changes. Good governance cannot be forced from the outside, but companies that have good governance will find it easier to raise capital from the market.

What is being done to protect the interests of the general public who have invested in companies that get de-listed by the stock exchange?

Two things have to be done for this. Companies that have good governance should be honoured and placed in a distinct group. If this is done, it will send the right message across to other companies. A company with good governance always works for the investors' good by disseminating accurate information.

Companies that cannot meet this criterion should be placed in another category from where they can make improvements and eventually manage to upgrade themselves to the first category. This will protect the investors’ interests. Well-informed investors are protected investors. This is the system that is in practice in international stock exchanges too. In our new law, there are provisions for alternative market systems such as the over-the-counter (OTC) market which can be managed by the stock exchange itself or it can be set up elsewhere. With such an arrangement, investors can sell their shares any time they want and exit the company. However, the share prices of such companies will not be quoted publicly.

What is SEBON doing to educate the investors?

For this, looking at the market's condition and the board's resources, we are disseminating information through different newspapers, SEBON's own web site and other publications. This is meant to increase the investors' analytical capacities. Similarly, the new regulations will require brokers to inform investors about investment risks. The new law has the provision to ensure dissemination of information through the market mechanism and penalising the companies' directors who are thrifty with information.

The IPO expenses are said to be too high. For example, in Gorkha Development Bank's IPO recently, the collection was Rs. 100 million and, for this, it had to pay Rs. 150 million to the issue manager. Isn't this very expensive?

According to the rules, the maximum that the issue manager can charge is 3 per cent. Last year we conducted a study and found that the fee collected was not significantly higher than what is allowed by the law. We have not received any information that Gorkha Development Bank had to pay higher than what is specified by the law. Therefore, it is difficult to comment on this. It also depends on the terms of the contract . If even the publication of the application forms has been done by the issue manager, the company has to cover these costs too but this cannot be called a fee paid to the issue manager.

How is the monitoring capacity of SEBON?

Our main task is to formulate policies. These forthcoming regulations will incorporate many of these policies. They will specify the standards to be maintained by the brokers, dealers and merchant banks. Our job then will be to monitor implementation and to initiate action against violators. We are happy with the level of work that we have been able to carry out so far given our limited means. We do not have enough budget and that is why our policy-making and follow up activities have not been as good as they should be, but we are trying our best.

Even though we have been given an immense responsibility, we do not have sufficient manpower. Out of our 22 staff members, only 10 are in the "officer" level. Due to the lack of money and the fact that we are a government body, we cannot hire specialists in law and accounting by paying the market rates. But now there is a new law that will increase the Board's resources. However, the board is still not sufficiently autonomous so we have to carry on in close association with the government.

Now, even commodities exchanges have started being set up. For example, COMEN has already started operation. What is being done to monitor and regulate these commodity exchanges?

We have told the government that the commodity exchanges should be regulated. In India, SEBI started regulating commodity exchanges from 1998 and they have developed so quickly with the help of modern technology that they now have been established as fully accountable exchanges. Therefore, we have told the government that the newly opened COMEN should be regulated for its qualitative development. We have to encourage such exchanges.

There were some institutional investors and market makers in Nepal's security market a few years ago. They have now disappeared. What is being done to bring them back?

The first thing to be done to bring institutional investors back is to increase the market size. The disclosure provision being introduced is towards this end. But we cannot say that institutional investors have disappeared. Our securities market has been developing mainly through retail investors. Collective investment vehicles are not sufficiently developed as yet. The reason for that is, again, the small size of the market. We are now hoping that telecom and electricity companies and some other closely held companies will also enter the securities market. That will increase the market size. In addition, we are also creating regulations for collective lending vehicles like mutual funds.

It is said that some finance companies that were acting as market makers went out of the market due to the rules introduced by Nepal Rastra Bank some years ago prohibiting banks and finance companies to hold shares in similar companies. What do you say to this?

There are other reasons as well, according to one of our studies. For one, earlier there were problems in processing the orders to buy and sell shares. After the planned automation is completed, the orders of the market makers and investors will go together and every order will be anonymous. Earlier, the investors' orders were given priority over the order of the market maker so that the market makers could not make their position on any scrip. Another reason was, again, the small size of the market. Also, it is necessary to make some reforms in the taxation rules. Marketing making is such a job in which in some years, there may be losses. The tax rules should allow such losses to be carried over to the next years.

And the market does not rating agencies as well.Is anyone coming forward to act as a rating agency?

Some parties showed interest some time back and contacted us. We told them that we would recognise them if they go ahead but they just vanished. May be, they did not find it feasible after looking at the market size and the unrest in the country. But now the market size has increased and there is scope for the rating business. Finance companies can be rated. If this happens, it will be easier for depositors. Likewise, insurance companies and corporate governance within companies can also be rated. That is why we are hopeful that someone will now come forward to function as a rating agency.

What is the reason behind the volume of trade in government securities being so low?

The main problem is of supply. The primary market of the government securities is dominated by institutional investors and they do not have a liquidity problem. Therefore, they are in no hurry to sell them. Additionally, the tax rules have also played an important role. For example, when retail investors sell such securities, the tax deductible at source (TDS) is 6 per cent, but for institutional investors this rate is 15 per cent. That is why there is no integrated market for these securities.

It is said that 'insider trading' is rampant in the securities market. What is the situation in reality?

The majority of the fluctuations in the market are due to rumours. That is why we want to streamline information flow and make the parties concerned accountable for the flow of information. After these things are sorted out, we are hopeful that insider trading and rumour-driven fluctuations will be controlled. When the system is in place to identify the buyer and seller and to identify if there is any large volume of buying and selling, insider trading will be automatically restrained. If people notice that insider trading is taking place, they should inform us and this will help us in taking the necessary actions.

Do you have any other comment on the new Securities Law?

It would have been better for the Board's autonomy, if the law had provided for two full-time members in addition to the chairman. This would be similar to the Nepal Rastra Bank where there are two deputy governors. Under the present provisions all the regulations have to be prepared by the Board and approved by the government. It would be better if the major regulations were formulated by the government and only the minor ones were made the Board's responsibility. Another improvement would be to provide for more professionals as Board members whereby independent persons would be hired as professional.

One good point of the law is that it has provision for the identification of investors. Moreover, it has specified the responsibilities of all the stakeholders like the Security Board, the Stock Exchange and security professionals.

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“We're also thinking of starting transactions in derivatives”

Rewat Bahadur Karki
General Manager, Nepal Stock Exchange Ltd.

Where is the Nepali securities market heading?

The reforms in the Nepali securities market have been very slow compared to the progress in the financial sector reforms. For example, the "Open Out-Cry" system is nowhere in practice even in the SAARC region, but it is still in practice here. Therefore, work is underway to put an end to it within the next three to four months. Similarly improvements are being made in areas like blank transfers. Matching transactions have been stopped because the fluctuations in the market seen after the monetary policy was announced in July were caused by this. A circuit breaker system too has been introduced to stop extreme fluctuations in the share prices. If circuit breakers had not been applied, there were chances that the situation of 2056/57 BS could have been repeated.

We don't simply apply the circuit breaker. We started asking for written clarification from the company concerned to explain if there is any reason for the sudden change in the price of shares. If the board of the company has made certain decisions and the information of the same has not formally reached the market, the company should disclose this. The company's shares are allowed to be traded even on the same day after such information is provided to the public. Our purpose is to ensure that the transactions are not just fuelled by rumours.

Only shares and debentures used to be traded before whereas we have now started transactions also in government securities though this has not really picked up due to some hitches. We are also thinking of starting transactions in derivatives. The new Securities Law allows some facilities to be provided to unlisted and de-listed companies as well. We are therefore thinking of starting 'over-the-counter' (OTC) trading of these companies' securities.

That means work for floor automation has started. But what is happening for the full automation of the entire business?

Floor automation will be completed by April this year. We are also thinking about automation of settlement and clearing. But the Central Depository System (CDS) is not in the plan. CDS requires a different system and it is very expensive. Even if we set up the system, it will be very costly to operate and maintain. So, it will have to wait. Added to this, we need a Trust Law to operate the CDS. Nevertheless, our next step will certainly be towards CDS.

Is there any progress in the plan to increase the numbers of brokers?

When the market capitalisation was only Rs. 10 to 15 billion, the number of brokers was 25 and now it is 23. That is the reason for the low level of competition between Nepali brokers. It is necessary to make the brokers' services professional, qualitative and competitive. Previously, we had the authority to appoint brokers but according to Clause 57 of the new law, we can only recommend them now. We are formulating the criteria for this recommendation. After we get the approval from the Securities Board, we will publish advertisements in newspapers and begin the process to appoint new brokers.

What is happening to the plan of creating a SAARC regional index and starting cross-border listing?

Worldwide, there is a trend to unify various stock exchanges. Nepal also became a member of the South Asian Federation of Exchanges in 2001. Now we are in its executive committee as well. This organisation helps in cross-border listings and facilitates cross border trade. But without capital account convertibility, cross border trade is not possible. If our currency becomes convertible and cross border trade is started, it will surely encourage foreign investment through the stock market. We are planning to put a proposal before the government to make policies in the coming year's budget to allow non resident Nepalis (NRNs) to invest in foreign currency in the stock market. Regarding the South Asian Stock Market Index, there has already been an agreement about it and the job will be entrusted to Dow Jones.

The transactions in the NEPSE floor are mainly in the securities of banks and finance companies, not in the real sector companies. What is being done to improve this?

Yes, elsewhere, the real sector is prominent when compared to the banking and financial services. But here, it is just the opposite, which is unnatural and needs to change. But this can't be achieved by reforms in the stock exchange alone. It needs a whole package of reforms, which means that, there should be simultaneous reforms also in the government's annual programmes and monetary policy. Another reason for the underdevelopment of the real sector is that companies belonging to this sector are not transparent enough. They maintain multiple accounts so they must be made to follow international accounting standards and should be required to make better disclosures. Of course, the disclosure practices of the banks desire a lot of improvements but they are relatively more transparent. For that purpose, the Company Registrar, the Ministry of Industry, Commerce and Supplies, and the Finance Ministry should do something. Also the help of the Nepal Accounting Standards Board can be mobilised for this purpose. Currently, companies get as much money as they want from banks and they do not have to repay their loans. So, why should they bother to go public? If rules are stricter and if action is taken against defaulters, more companies will be forced to go public.

Yes, Nepali manufacturing companies are not able to do well because both our neighbours China and India have already adopted liberal economic systems and their companies are much more competitive. Still the service sector can do well here and such companies can go public. However, we should not forget that only the stock exchange can't do well when the overall economy is stagnant.

What are your views on the Securities Law that has just been promulgated?

That law has been in force since January 13 and it has given a lot of authority to the Securities Board of Nepal (SEBON). It has a lot of necessary provisions that were absent in the previous law. But in some matters, it has added more hassles for the stock exchange. Because we have to get the Board's permission even for small decisions, not only will our work take more time but it also looks like our autonomy has been restricted. For example, it is all right for the Board to give licences to brokers but now the Board controls the issuance of license to the representative that brokers send to the floor. The custom is that a broker appoints three representatives and previously they could be approved by the exchange itself. But now they have to be registered with the Board. Similarly, the Board's permission is needed even to form a minor committee. Therefore, we feel that the law has become restrictive even in minor details. The regulator is a facilitator and it should not get tangled up in such details. The stock exchange is not allowed to make even a small guideline. The objective of any law or policy should be the market's development. The Board was going to fix even the percentage for the circuit breaker but finally this right was allowed to remain with the stock exchange. Now we are conducting research to distinguish companies that have negative or positive net worth so that the fees charged from them can be made different. Likewise, according to the new rules, different charges are to be imposed on investors. This will only increase the investors' costs and this is a time to encourage them, not drive them away. So these provisions are inappropriate. The stock market right now is in its infancy. When it grows, the revenue will grow automatically. As the law has tried to control it in its present stage, this is not a good omen for the securities market. It needs further amendments to make it compatible with the spirit of liberal economic policies. In fact, this law was rushed in because the previous ordinance had expired and needed to be replaced. That is why there was no time for ample homework in its finalisation.

Market makers have disappeared from the stock market. What is the reason for this?

One of the main reasons is the policy of the Nepal Rastra Bank. Two years ago, NRB formulated rules that prohibited 'cross holding' of shares between banks and financial institutions. Market makers are financial institutions and the bulk of the trading in our stock exchange is in banks and finance companies. That is why there are no market makers now. In order to reform the market, new policies have to be formulated and special provisions have to be made in this area. Market makers are very important and can be the solution to the complaint that the market is dominated by a few individuals. Market makers other than financial institutions will take a long time to evolve. Therefore, my opinion is to utilise what we already have. Yes, we do have to stop unhealthy practices in the market. For example, the margin lending has to be controlled and we have already requested the Central Bank to rethink its policy.

It can be observed that the bulk of the shares being traded in the stock exchange are those of the banking sector companies. The reason for this is said to be the provision that banks need to disclose their financial situation every three months. Can't the other public companies also be made to disclose their accounts every three months?

The responsibility for this falls on the Ministry of Industries, Commerce and Supplies. If the ministry or the department orders the companies to disclose their financial statements like the Central bank orders the banks, there is no doubt that they will make these disclosures.

What efforts have been made to stop 'insider trading'?

Yes, there are indications that insider trading is taking place. For example, in one bank, people other than the directors had the information that the bank was issuing bonus shares and there was a lot of buying and selling of that company's shares even before the bank's directors decided on this. This type of insider trading is invisible and the challenge is to make it visible. Currently, we are trying to see if there is circular trading, i.e. trading among close relatives and friends. For this, we are conducting surprise checks at the brokers' offices. Similarly, we are revising the circuit breaker system to implement different rates for companies which are in profit and for ones that are making losses.

What are you doing to improve the governance of the stock exchange company itself?

It is important to improve the market, but institutional improvement is more important. For that, the capability of the stock exchange has to be improved. Since there were excess employees, we reduced the number through a voluntary retirement scheme. The number has been reduced now to 23 from the earlier 43. But the quality of work has not diminished. This proves that the same work can be carried out effectively even with a less number of people if the leadership is good. The propensity of employees to go to the brokers' offices has stopped. Steps have been taken for promotions and increasing the employees’ incentives.

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Expectations from nepal stock exchange

By V B Shah

As the second youngest stock exchange in the region, the Nepal Stock Exchange naturally had to go through teething problems. But this period seems prolonged as despite a good 12 years of existence, it is still at the same stage where it started - the only exception is that the market turnover has increased due to the efforts of the Nepal Rastra Bank and the legislations that govern banks, financial institutions and insurance companies. Otherwise, the stock market would have been nowhere. Due to the many listing-unfriendly provisions in the Nepali laws, the stock exchange's list does not have a single company which has no legal compulsion to offer shares to the public.

It is said that when you ask any individual what is hindering him to excel in his area of activity, the prompt answer you get is: "Lack of appropriate rules and regulation". The Nepal Stock Exchange is no exception, and you get the same reply whether you ask regulators, intermediaries, serious investors or wheeler-dealers. The irony today is that the best Constitution (as claimed by its drafters) needs an emergency amendment within 15 days of its existence. Hence forget about other Acts, Rules and Regulations and learn to live with this reality. But this coin too has the other side. A non-performer always looks for excuses and what better excuse can you get than lack of, or inadequate, legislation!

The Nepal Stock Exchange has of late seen some positive indications under the leadership of its new General Manager Rewat Bahadur Karki, who is trying his best to bring in good working practices, automation and clearing of deadwood through voluntary retirement schemes and hiring professionals to make it a modern exchange. But the issue is how far can he go and how wide can he spread the capital market which at present revolves around a handful of big investors.

Challenges, Challenges and Challenges…

It is not easy as our Stock Exchange is looked upon by all as a place which should be at par with at least other exchanges of the region. If so, it needs to address the following issues to start with:

Firstly, it has to meet the aspiration of investors from outside the Valley too. Today they are mute spectators to the rise and fall of indexes. Their savings are not properly channellised and they are left on their own. This is actually a great disservice to the people from outside the Valley, to the capital market and to the country as a whole. Do we need to halt traffic, burn tyres and close the country to get a regional stock exchange or at least to provide a mechanism to channellise the savings of the people from the Kathmandu Valley to the capital market? If it is still a distant dream, then ask the private sector to operate it and they will be happy to do so.

Another area which requires immediate attention is providing better information to the investors. At present, if you go to the exchange during trading hours, you will see hordes of people jostling to get a view of their orders being executed by the brokers. They feel lucky to get even a glimpse, forget about the returns.

Automation of the work-flow is another area which is of prime concern. Though the stock exchange has recently received a grant for the software to address this issue partially, the real benefit of this will be reaped only after its implementation and integration.

Our exchange, though small, has a no-profit policy, but we wonder what it has done to enhance the skills of brokers and other capital market intermediaries. No training has been conducted during the last 12 years. What sort of professionalism is it trying to develop without even carrying out a formal orientation to some broker's representatives who execute deals on the floor?

The irony is that we hardly press for enhancing the standard of the broker's office, developing professionalism and updating information but we opt for short-cut methods by increasing their number. Similar was the case with travel trade, carpet, garments, and Pashmina industries. And very soon, the same could happen to the stock exchange. Though the exchange must have concerns to address the above issues, what is the guarantee that this also does not become a victim of political appointment like in universities/missions abroad where the vacancies are being shared by political parties on the basis of their representation in Parliament?

The pressure on the stock exchange to appoint new brokers is so high that the exchange is determined to increase the numbers to 50 which is the highest it can accommodate in its present infrastructure leaving no room for the future.

It also needs to have its view on speculation at the IPOs fuelled by lending from banks and finance companies. Though one may say that it is the prerogative of the banks, anyone with common sense will argue as to what sort of social responsibility are we fulfilling by providing margin lending at around 6 per cent interest and project finances at around 12 per cent? Why are we blocking genuine small investors to reap the benefit of IPOs and adding fat to the already fat banks and finance companies' reserves by making oversubscriptions of primary issues of even fresh companies? If the Nepal Stock Exchange does not come up with its position regarding these issues, then a finger may be pointed at it and it may be asked whether its decision makers have their share in this "pie".

The Nepal Stock Exchange recently de-listed some companies which were either closed down or had not paid their listing fee. It may look fair for the exchange to do so, but where will the small holders who have shares of those companies go? The small holders know only the stock exchange where they were earlier trading in those shares. We have seen companies like Nimrod, Necon, Himgiri Textiles, Leatherag Bansbari and a number of others whose whereabouts are unknown today and the stock exchange does not have the moral ground to wash off its hand simply by delisting them.

(Shah is CEO of National Investment Capital Market Company Ltd.)

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Stock Market Development in Nepal: Judging Against Key Indicators

By Dr. Bijay KC

During the last one-and-a-half decades the Nepali financial sector has shown significant growth. Till the early 80s, Nepal had only two commercial banks, two development banks, one provident fund corporation and few insurance companies. With the adoption of privatisation and the economic liberalisation policy by the government, the financial sector grew rapidly, especially in quantitative terms. By the end of July 2005, the financial sector included 17 commercial banks, 59 finance companies, 34 development banks (including five regional development banks), 18 insurance companies, 19 cooperatives with Central Bank approval, 116 postal saving banks and 47 non-government micro-credit institutions. Besides these, there are also one Employee's Provident Fund, one Deposit Insurance and Credit Guarantee Corporation, one Credit Information Bureau, one Rural Self-Reliance Fund, and one Citizen Investment Trust. During this period some discernible improvements were also made in the stock market. In 1994, Securities Board Nepal was established with the main responsibilities of regulating, supervising, and monitoring the securities market. Similarly the Securities Exchange Centre was changed into the Nepal Stock Exchange Limited with the objectives of providing a secondary market for securities transaction and ensuring smooth trading of securities. For this, an open out-cry system of securities transaction was introduced and investors were allowed to deal in securities only through licensed brokers.

With the development and reform in the financial sector, the equity market activities grew. Over the past 12 years the stock market has made some noticeable progress. For example, between the fiscal year1993/94 and 2005/06, the number of listed companies in Nepal Stock Exchange Limited increased almost from 62 to 135 and the value of stock listed rose by almost seven times from Rs. 14 billion to Rs. 96 billion. Likewise, the number of securities listed with the exchange has increased five times from 43 million to 226 million and the number of annual transactions increased 600 times from around 9,000 to 5.8 million. During this period NEPSE index jumped to 386. Despite this, the stock market in Nepal is still at a developing stage and is yet to show visible impacts on the economic growth of the country.

Stock market and the Economy

Despite the increase in the number of listed companies, their market capitalisation and their annual turnover, the securities market has yet to make its presence felt in the overall economy of the country. The securities market is highly dominated by government bonds. In 1984-85, trading in government securities accounted for about 99 per cent of the total volume of securities transactions. In 1990/91, it accounted for about 97 per cent of the total volume of securities transactions. Between 1984/85 and 1990/91, the volume of transactions in the government bonds increased from Rs. 270 million to Rs. 914.2 million, growing at an annual compound rate of 19 per cent. [Securities Exchange Centre, 1992]. By 1980/81, the total volume of outstanding bonds was Rs. 1.20 billion, which increased to Rs. 18.5 billion in 1990/91 and to Rs. 28.54 billion in 2000/01. By the end of the third quarter of 2006, the volume of treasury bonds reached Rs.37.3 billion. Of the total volume of outstanding bond the business enterprises owned only about 2 per cent and individuals about 5 per cent in 1990/91. In 2005/06 business houses owned about 1 per cent while individuals owned about 20 per cent of total outstanding bonds. This shows that individuals are increasingly investing in the government bonds over the 15 year period. This, however, provided little impetus to the development of the stock market because a secondary market in bonds was not allowed during this period.

The level of stock market development and its impact on the national economy can be measured by using various indicators such as the size of the stock market, liquidity, concentration, and volatility. Indicators of stock market development are presented in the following table:

Stock Market Size

Generally, a large stock market size indicates a developed stock market. One of the measures of the stock market size is the number of companies and scrips listed with the stock exchange. The size increases with the increase in the number of listed companies. In Nepal , the number of companies listed with the Nepal Stock Exchange Ltd. was 66 in 1993/94 which increased to 135 in 2005/06. Similarly the number of listed securities increased from 43 million to 226 million during the same period. Similarly, the paid up value of the listed securities increased from Rs. 2.18 billion in 1993/94 to Rs. 20 billion in 2005/06. It is, however, interesting to note that despite the increase in the number of companies and paid up value of the securities listed with the exchange, only about one-tenth of the companies registered with the Office of the Company Registrar as public limited companies were listed with the Nepal Stock Exchange during the period. Most of the listed companies belong to the banking, finance, and insurance sectors. While only few companies from the trading, hotel, manufacturing, and aviation sectors are listed, very few companies from power, information technology, and construction sectors have entered the organised stock exchange of the country. This indicates that firms tend to avoid the stock market as an alternative source of long-term capital in Nepal .

Stock market size is also measured in terms of market capitalisation ratio which is the aggregate market value of the listed shares divided by Gross Domestic Product. This ratio indicates the relative importance of stock market to the national economy and assumes that the stock market size is positively correlated with the ability to mobilise capital and diversify risk. The market capitalisation ratio has, on an average, been only around 0.08 for the period between 1993/94 and 2005/06. It is important to remember that in countries with developed stock market, this ratio is greater than 1 and in many developing countries it is between 0.2 and 0.4. Low market capitalisation ratio in Nepal indicates that the stock market is yet to show its impact on the country's economic activities.

Liquidity

Liquidity in the stock market parlance refers to the convenience and ease in buying and selling securities in the market. By allowing investors to alter their investment portfolios conveniently any time at a low cost, liquidity makes the financial assets less risky. This ensures efficient allocation of resources and promotes long-term economic growth. Liquidity, measured in terms of the total value of shares traded in the stock market as a percentage of Gross Domestic Product, indicates the extent of ease in trading in stock market in a country. It is expected that the volume of organised trading of equities as a share of national output increases when such trading is less costly and easy. Evidence shows that countries with relatively liquid stock markets tend to grow much faster when compared to countries with illiquid markets.

The value of shares traded accounted, on an average, for about only 0.0037 of the GDP during the period between 1993/94 and 2005/06. It was normally below 0.004, except in a few years. In countries with a developed stock market this figure is as high as 0.4 and in many developing countries the values of shares traded vary in a range of 0.001 to 0.01 of the GDP. Low ratio of value of shares traded to GDP indicates that trading in equity relative to the size of economy is very low in Nepal .

Another measure of liquidity of stock market, the ratio of value of shares traded to market capitalization, also known as turnover ratio, is indicative of the trading relative to the size of the stock market. A high turnover ratio indicates low transaction cost and relative ease in buying and selling of shares. Experience shows that countries with a high turnover ratio develop faster than countries with a low turnover ratio. In developed countries this ratio is greater than or very close to 1 whereas in many developing countries this ratio stands in the range of 0.15 to 0.3. In Nepal the turnover ratio has remained very low, 0.042, and highly fluctuating, during the period between 1993/94 and 2005/06. The value of shares traded relative to both GDP and market capitalisation is on a decline since 2001/02, except in 2004/05, indicating growing illiquidity in the country's stock market.

Taken together these ratios i.e. market capitalisation, value of shares traded to GDP, and turnover, indicate that the stock market in Nepal is very small relative to its economy, and highly illiquid and it is yet to make its presence felt in the national economy.

Concentration

Concentration in a stock market is generally measured by computing the share of the 10 largest stocks to the total market value of shares. A country's stock market is considered highly concentrated if a few large companies dominate it. In other words, in a stock market which has a high concentration ratio, the shares of a few companies account for a major percentage of the total market value and are traded most frequently relative to stocks of other companies. High concentration is not desirable as it adversely affects liquidity. Countries with family-owned, closed enterprises and limited number of listed companies have high concentration ratios.

Countries with a developed stock market have concentration ratios of about 0.2 of the market whereas in countries with undeveloped stock market this ratio is as high as 0.9. In Nepal the ratio was on an average around 0.67 over the past 13 years which indicates that the market value of shares of the 10 largest companies account for two-thirds of the total market value. The concentration ratio is as high as 0.8 when it is computed on the basis of turnover. This indicates that the Nepali stock market is dominated by the largest 10 companies in terms of either market capitalisation or turnover. It is interesting to note that of the 10 companies dominating the market in 2006, nine are commercial banks, indicating that the stock market is highly dominated by them. High concentration has adversely affected liquidity and the significance of the stock market in the national economy.

Volatility

High volatility in the stock market denotes risk in equity investment. However, it should be understood that high volatility does not necessarily imply an undeveloped stock market. It is generally expected that stock markets, when well developed, absorb risks in financial assets and offer higher return with less volatility. Put simply, it means that as an indicator of a country's stock market development, less volatility is preferred. Volatility may be measured as a 12-month rolling standard deviation of market returns. Higher standard deviation means higher volatility, and more risk.

Indicators of Stock Market Development in Nepal 1993/94-2005/06
Years	Market Capitalisation to GDP	Value of Shares traded to GDP	Value of Shares traded to Market Capitalisation	Value-traded ratio to volatility
1993/94	0.07	0.002	0.0311	0.001
1994/95	0.06	0.005	0.0813	0.011
1995/96	0.05	0.001	0.0170	0.004
1996/97	0.05	0.002	0.0328	0.012
1997/98	0.05	0.001	0.0142	0.003
1998/99	0.07	0.005	0.0632	0.017
1999/00	0.12	0.003	0.0268	0.005
2000/01	0.10	0.006	0.0583	0.006
2001/02	0.09	0.004	0.0444	0.003
2002/03	0.08	0.001	0.0163	0.005
2003/04	0.09	0.004	0.0518	0.077
2004/05	0.12	0.009	0.0735	0.122
2005/06	0.17	0.006	0.0357	0.173

Although volatility in the Nepali stock market was high during the initial years, it was on a decline till 1996/97 indicating that equity prices in the stock market tended to stabilise during this period. From 1998/99 onwards, volatility had a wider fluctuation but it showed a tendency to rise consistently till 2001/02. Countries with high inflation rates seem to have higher volatility in the equity markets. In general, volatility in the Nepali stock market is less than the average volatility of other developing countries. The reason is mainly low volume of trading of equities due to low demand. However, in recent years volatility has increased due to the increase in the volume of trading triggered by the speculative motive of investors.

Analysts argue that developed stock markets should not only provide high liquidity but also handle large volume of trading with less price swings. In other words a liquid market should allow large volume of trading with less volatility. One of the indicators to measure this is a ratio of value-traded-ratio to volatility. A high ratio indicates the ability of the stock market to provide liquidity and handle risk. Although this ratio showed an increasing trend during the last three years, it indicates the Nepali stock market's inability to handle risk relatively to the volume of the trading of shares. A positive but very weak relationship is observed between volatility and the volume of trading of shares in the stock market.

Various measures of stock market development indicate that the Nepali stock market is undeveloped and has failed to show significant impact on the national economy. The small market size has made it vulnerable to manipulation and price rigging. Low turnover ratio and value-traded-ratio to volatility, and high concentration ratio indicate that the stock market is highly illiquid and risky. Investors tend to avoid the stock market because they cannot invest in securities according to their risk-return preference. Similarly, firms shun it because the stock market is a less reliable source of raising funds. Due to this, the financial system in Nepal has remained basically bank-dominated.

(Dr. KC is Professor and Dean of South Asian Institute of Management)

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