1. Introduction
The financial system in any country consists of a large number of
institutions, instruments and markets. Financial intermediaries range
from money lenders and commission agents to banks, insurance
companies, brokerage house, investment trusts and stock exchanges.
Financial instruments (or assets) range from coins and currency notes
to government bonds, mortgages, corporate stocks and the more
exotic derivatives of high finance. Markets dealing with the trading of
financial assets can be categorized as being either formal (as in stock
exchanges with centralized trading floors) or in formal (as in over the
counter or curb markets).
The objective of this paper is to highlight first in broad terms the role
of financial systems in economic development and then to focus on the
specific contribution that stock markets can make to the widening and
deepening of the financial sector. We then describe the evolution of
stock market in Pakistan and high lighted in particular the factors
which have the constrained effective operation of equities markets in
the country. Finally we make recommendations for enhancing the role
of stock markets.
2. The Role Of Financial Systems In Development
2.1 Role Of Financial System
the basic role of financial systems is to engage in the process of
intermediation by mobilizing savings from a large pool of small savers
and channelizing these funds into productive investments by a
generally much smaller number of borrowers. The key to success in
intermediation rests on the ability to pool together and thereby reduce
the risks associated with individual investments.
In the absence of financial services, an economy is relegated to
activities of subsistence or barter. This greatly limits the scope for
specialization and the achievement of economies of scale through
operation of modern, large scale technology. Also it is not possible to
separate the timings of consumption from production unless physical
inventories of goods are build up. Altogether, economies with
underdeveloped financial systems are likely to have lower incomes,
other things being equal.
There is general recognition now that finance is the key to raising the
level of investment and savings and there by promoting the process of

2. economic growth. Channelizing saving to investors with more
productive uses for them enhances the income both savers and
borrowers. Without an efficient financial system, lending can be costly
and risky. Competition among financial institutions ensures that
transactions costs of intermediation are minimized, that risk is
allocated to those most willing to bear it and that the most promising
investment opportunities are discovered.
2.2 Evolution Of Financial System
Traditionally, financial system of developing countries have been
dominated by informal finance, consisting primarily of loans from
family members or friends or money lenders. Such managements have
had the advantages of low transactions costs, responsiveness to
borrowing need frequently for emergency consumption purposes and
low rates of non-repayment. However, they have greatly limited the
scope for financial intermediation due to the largely personalized
nature of the contacts. It is clear that as economies grow, thes
arrangements need to be diversified and supplemented by the services
that only formal institutions like commercial banks and capital markets
can provide. For example by transforming the size and maturity of
financial assets, such institutions can more effectively mediate
between the many small savers and depositors who prefer liquidity
and the few large borrowers who need long term loans to finance
investment. The emergence of financial institutions not only potentially
raises the volume of savings by offering higher rates of return with
relatively lower level of risk but also changes the composition of saving
away from physical assets like land, property, jewellery, etc, towards
financial assets, which enables more productive investments to be
undertaken from the overall economy point of view. Thin increase in
financial assets is referred to as ‘financial deepening’.
2.2 Polices In Financial Sector
In the initial stages of development of the modern, formal financial
sector most countries, including Pakistan, have chosen the path of
controlling interest rates, directing and rationing the allocation of
credit to priority sectors and using the banking system for inexpensive
funding of government activities. This has undermined the process of
financial development and led to ‘financial repression.’ Saving have
depressed and other distortion have been created, including the strong
preference for debt versus equity financing of long term investment in
the presence of regime of low interest rates. Also, this has resulted in
a degree of ‘financial distress’ due to low spreads and default in

3. repayment of directed loan. Simultaneously, the preferential access to
credit of the public sector has tended to ‘crowed out’ the private
sector.
2.3 Financial Sector Reform
Recognition of these problems had led many countries, including
Pakistan, to pursue the path of financial liberalization in recent years.
There has been extensive deregulation of interest rates, concessionary
credit schemes have been phased out, government owned banks have
been privatized, terms of government borrowing have been linked
more closely to market rates and permission granted for the
establishment of new types of financial institutions (investment banks,
leasing companies, mutual funds, etc.) in the private sector and
removal of restriction on foreign portfolio investment. These reforms
promise to enhance the role of capital market in particular in the
financial system. We turn now the role of equities markets in the
process of development.
3 The Role Of Stock Markets
The primary role of stock markets is to provide long term equity
finance for the corporate sector. Trading in equities enables
intermediation between conflicting maturity preferences of lenders and
borrowers. Stock market also potentially promote broad-basing of
ownership of financial assets and the reallocation of funds among
corporations and sectors.
3.1 Choice Between Debt And Equity
The management decision regarding choice between debt and equity
modes of finance is contingent on a number of factors which include
risk and cost of capital. Under a private enterprise system the
prospects of individual gains are inevitably associated with the
possibilities of loss, and this hazard rests on those who have supplied
the capital. The hazard shows itself in the form of uncertainty both of
income to be received and recovery of principal invested. It is these
uncertainties that constitute risk.
If a corporate entity fails to earn a profit and continues to spend more
money than it takes in, a time will come when it will be unable to meet
its current obligations.

4. When that happens the company becomes insolvent or bankrupt. In
such situations all debts must be settled in full before any equity
claims can be paid.
Because of the priority of debt claims before equity claims the creditor
is ready to supply long term capital in the form of debt at a lower cost
in the form of interest. The creditor, therefore, does not demand a
proportionate share in profit. It may be pointed out here that the
position of a creditor is negotiated one as a result of a bargain
between the firm and the supplier of the funds. The decision of
accepting a particular level of risk, there fore is voluntary on both the
sides.
If we compare debt and equity securities from the point of view of
allocation of income, holders of debt securities have to be satisfied
with low and fixed incomes. These instruments also enjoy stable
market values because of lower risks. on the other hand there is lot of
variation in the income of equity security with the result that the price
performance is more volatile resulting in the higher degree of risk. In
accepting this higher level of risk, equity holder on the average expect
a higher rate of return.
The mix of debt and equity, that is, the capital structure differs from
industry to industry. Industries with stable sales performance and
stable margins (selling price-cost relationship) permit use of more
debt. On the other hand, an industry having less stable sales
performance and volatile margins may have a lower debt to equity
ratio.
Therefore, companies in stable sales industries will enjoy lower cost of
capital compared with companies in volatile sale performance
industries. Also the capital structure affects the stock market
performance of the shares of company. A company using more debt
than the industry averages may have lower share price because of
higher risk. Use of more debt may result in higher earnings per share
but they may be offset by increased risk, resulting in an adverse price
effect .
The mode of financing used is also influenced by the motivation to
keep control. A firm may avoid issuing new equity for fear of dilution of
control and, therefore, the growth requirements may be financed
through internal equity (retained profits ) only. Debit may also be used
when this source falls short of the requirement. This could result in a
firm moving away from the optimal debt to equity ratio.

5. 3.2 Equity Markets And Development
Broadly speaking there appears to be some correlation between
indicators of development of equity market in a country and its overall
level of development, as shown in table 2.1. The table indicates that,
as of the late 1980s the equity market in Pakistan was relatively
underdeveloped. The position has improved significantly in most of the
emerging markets in developing countries, including Pakistan, in the
1990s, following the process of financial liberalization and, in
particular, due to the flow of portfolio funds from developed countries
of these emerging markets. As such, while ratios have improved the
relative standing of Pakistan has not improved dramatically.
3.3 Constraints In Development Of Stock Markets
A number of factors have traditionally been responsible for the under
development of the equity market in Pakistan. We have already
referred to the government policy till recently of keeping interestrates
artificially low, thereby leading to a strong preference for debt versus
equity financing. Also, the tax system has increased the attractiveness
of debt and firms have remained highly leveraged in Pakistan.
Table 2.1
Equity Market Indicators (1987)
Per capita Average market Turnover ratio
Income Capitalization (% of
average
(US $) as % of GNP
capitalization)
Developed Countries
Japan 15760 92
93
U.K 10420 80
72
U.S.A 18530 58
93

6. Germany 14400 21
161
France 12790 18
56
Developing countries
Malaysia 1810 58
23
Korea 2690 19
111
Thailand 850 9
114
Mexico1830 8 169
Phillipines 590 7
62
India 300 6
19
Pakistan 350 5
9
In addition, there have been negative perceptions about the
operations of the stock market on the part of small investors. For a
stock market to perform its role efficiently, it must be transparent and
market based. The average investor in Pakistan sees the
market as being dominated by insider trading, frequent conflicts of
interest and low rate of payment of dividends. There is relatively weak
regulation and supervision of companies and reliable financial
information is generally not disseminated. Further, the stock remains
very thin and only limited quantities of corporate stock are traded as
sponsors are generally unwilling to dilute their ownership.
Consequently, there is great deal of volatility in share prices, which
frequently do not reflect accurately the underlying fundamentals. The
procedures for trading the stocks also impose high costs and are
cumbersome in nature. Altogether, the role of equity markets can be
enhanced only if the stock exchanges operate efficiently in a
competitive framework.

7. 3.3 Recent Stock Market Development
The boom witnessed during the 90’s in the stock market of Pakistan
can be attributed to a large number of factors, including, first, the
process of financial liberalization resulting in a rise and inflow of
foreign portfolio investment; second, the process of privatization and
the offering of new attractive shares; third, a greater measure of
political stability and investor confidence; fourth, improvements in the
operational efficiency of stock markets. It is of significance to note that
the two major measures of the share price index coincided with the
induction of popularly elected governments in 1990 and 1993
respectively. More recently, prices have plummeted in response to
weakening in the underlying macro economic fundamentals,
deteriorating law and order situation and exodus of foreign portfolio
capital.
The experience of the last years demonstrates that while the process
of financial liberalization and deregulation has conferred large capital
gains in terms of the increase in market capitalization (of over ten
times between 1989 and 1995), the result remain fixed. First, there
has apparently been an increase in the volatility of the stock market,
with large increase being followed by big decrease. For example, share
prices rose by as much as 48% in 1993, but have fallen since by 40%
(see table 2.2). This volatility is not only the consequence of
underlying law and order and political factors but also a reflection of
relatively short term nature of inflows of foreign portfolio funds. These
fluctuations in share prices have increased perceptions of risks and run
the danger of driving out risk averse investors from the market,
resulting in a degree of disintermediation. Second, while market
capitalization.
Table 2.2
Index Of Share Prices In Pakistan
Year SBP general index percent
Of share prices Annual change
[1980-91=100]
1981 93.5 -

8. 1982 100.3 7
1983 131.6 31
1984 182.4 39
1985 176.3 -3
1986 171.0 -3
1987 222.7 30
1988 260.6 17
1989 273.3 5
1990 283.5 4
1991 387.7 37
1992 334.0 -14
1993 493.1 48
1994 589.6 20
has increased rapidly, only a fraction is due to listing of new shares.
At its peak in 1992, stock markets in Pakistan mobilized capital of
about Rs 12 billion through new issues. This is equivalent to only about
10 percent of private investment in Pakistan. Therefore, the role of
equities market in mobilizing funds of investment in plant and
equipment remains very limited. Further reforms are required for an
enhancement in the role of Pakistan. We turn to these in the next
section.
Based on the above, we present some recommendations for
enhancement in the role of stock markets. In the context of choice
between debit and equity we have highlighted that firms are highly
leveraged in Pakistan. It is essential that the access to debt financing
from commercial banks and DFIs be reduced by requiring these
financial institutions to target for lower debt to equity ratios of 60:40
or even 50:50. as opposed to this, appropriate regulatory changes
may be introduced so that floatation of corporate bonds directly in
stock market are encouraged, especially by multinationals and other

9. large corporations. Other proposals generally to the development of
better financial infrastructure for operation of stock markets. These
include strengthening of regulatory provisions and better enforcement,
improvements in information systems and mechanisms for payments,
more neutral application of fiscal policy (especially with regard to
income and wealth tax) to all types of financial instruments, higher
standards of disclosure of financial information by companies,
improvements in auditing and accounting practices and greater scope
for financial innovation within a flexible regulatory framework. We
expect that progress in these areas will enhance substantially the role
of stock markets in the economic development of Pakistan in coming
years.