Explanation given so far

1. The Policymakers or the Manipulators: Who Are to Blame for the Recent Share Market Bubble and the Crash?

2. Explanation given so far • Most of the investors and experts are blaming • -The market regulators and • - The so-called market manipulators • for the recent bubble and the consequent crash. • But blaming regulators & manipulators exclusively for the recent bubble and the crash appears not to be convincing because • Manipulations, anomalies and irregularities has been in place for long.

3. Key remedies suggested so far A pure and simple solution Reform, Reform and Reform! In all spheres of the market including Governance of SEC Exchanges and Merchant Banks De-mutualization (separation of management from ownership), Increasing SEC chairman and members’ accountability, Opening a National Stock Exchange to in create competition in exchanges and so on. Beyond these, BB is asked to be cautious in case of monetary policy.

4. They have accepted that • Only policies formulated by SEC created the crisis. • Weakness of the SEC allowed manipulations and irregularities that created the crisis. • They have failed to identify that • Policies targeted to other sectors are also likely to create such crisis in this sector • Thus, the Bubble might be the creation of incentive mismatch across different sectors of the economy • General equilibrium of the economy was disrupted by certain Fiscal and Monetary policy that triggered the bubble creation • BB’s crash landing to clean their part of the mismatch induced the bubble burst. Problems with the policy suggestions

5. Sectoral balance vs. imbalance • If returns on resources are not equalized across sectors, resources will move toward a sector with the highest return • I have certain amount of fund. I want to invest. The fund size allow me to invest in real estate, share market and other businesses. I can also deposit it in banks. Where should I invest? • If the answer is not straightforward “Yes” for a specific option irrespective of who I am then there is sectoral balance in terms of incentives. Otherwise, there is sectoral imbalance • To put it differently, when people from all spheres of the economy bring their funds to invest in certain sector then there is a sectoral imbalance and that sector is bound to collapse to reestablish the balance.

6. Created imbalance centering Share Market • A large in crease DSE general index in 2009 and 2010 • Almost no increase in Market PE ratio over 2007 • The market data does not speak for overvaluation • But the market is overvalued indeed

7. Explaining the paradox

8. Flawed Banking PE ratio • When index was rising PE ratio was also rising for all but Banking shares. Banking PE was falling. • This means when all other shares were being over valued Banking shares were being undervalued. • Banks compose a large fraction of the market capitalization and thus it kept the entire Market PE ratio almost unchanged. • Bank’s profit is based on share market prices and thus when prices increase its profit increases but proportionately more than its own price increase per share. • Here is the basis of the bubble blast because the problem accumulated most here.

9. Policy mistakes in controlling the index • What the MoF, SEC and the experts suggest • To increase supply to the market because there is a • shortage of supply of good shares. • Precisely, that was a blunder which has created many problems. Seemingly it was a right policy though. • When price increases it can be for either supply shortage or demand excessiveness or for both. • The right policy to lower price depends on whether the shock is driven by demand or supply.

10. Total number of BO accounts was 18 lacs till December 2009. Of these, 7.5 lacs were added in previous 18 months spanning from June, 2008 to December 2009. • In contrast, 15 lacs new BO accounts were added in 2010. • The yearly turnover jumped from Tk. 1475 billion in 2009 to Tk. 4010 billion in 2010. (Need to adjust for frequency!) • The total turnover of Tk. 191 billion in April jumped to Tk. 386 billion in May. • The daily turnover went from Tk. 1 thousand crore in April up to Tk. 2 thousand crore in May and Tk. 3 thousand crore in October 2010. Continued-------------

11. Likely triggering factors • Now the question is what factors triggered that huge demand increase. What happened in May 2010 that added a huge momentum to the already energized market demand? • A few policy interventions • BB decision: No more bank loans for land purchase (2010-04-27) • Parliamentary body recommended that the government discourage savings certificates by cutting their interest rates (2010-04-22) • 50cr income legalised in the first nine months of fiscal 2009-10. “-----it is a common practice that many will legalize their money in the last days of the fiscal,”. NBR (2010-04-27)

12. The supply cannot be tripled within one year to match the • increased demand i.e., it is not possible to add 500 more • companies to the bourses. Supply increase is not easy in • asset market. Capital asset is slightly different. • Yes, it is possible in case of essential goods. If needed we • can do it for essential goods such as sugar. It will take 3 weeks • to import and 1 week to refine crude sugar and then bring • Refined sugar to the market. • Dual effect in case of asset market is also important. Dual • effect was less understood and thus blast was speeded up. • Induced supply pushed the index up. Failure to recognize that

13. S S S S’ D S’ D D S’ Continued ----- • Supply increase does not necessarily lower price • Only supply at lower than equilibrium price does it • Thus, a relatively high priced new supply will not lower the market price

14. Continued--------- • To induce supply, Book Building Method was introduced • to attract existing companies to the bourses. • We know that through this method some companies came • with a very high price aggravating the situation. • In fact, any company newly listed at the secondary market • pushed the index up. • This happens due to the inherent problem in the index • Construction • For example, the DGEN increased by 700 points on • November 16, 2009 due to GPs arrival in the secondary market

15. The jump in index in 2009

16. Index Calculation Algorithm: • Due to this faulty index calculation, market index was highly • inflated. • Thus, only secondary market price should be used in index. • Next day inclusion suggested.

17. Supply drive increased demand • One of the supply driven policies was directed increase of • paid up capital of the listed companies. • It was not driven by efficiency criterion or marginal analysis. • The declaration of paid up capital increase pushed the • market demand up tremendously. • Even the news of re-evaluation of company assets increased • demand. Biased re-evaluation induced huge demand. • Thus, the supply enhancing policy backfired due to a • substantial increase in demand.

18. Demand propaganda • They continued their demand enhancing propaganda until at the end of the bubble. • Denomination change of the 100 taka shares to 10 taka unit were creating a huge increase in market demand of shares. • Loan provision for bubbled items. SEC always permitted loans on bubbled items. • No restrictions at the beginning (probably!), then PE<=100, thereafter PE<=75, and at last PE<=40. Allowing loan for bubbled items intensified the creation of bubble.

19. Role of information • Role of price sensitive information • Media carries thousands of news to the listeners and readers daily. • None but share reports are price sensitive. May be information related to state of essential commodity market act on their prices. • But the information on share market creates an immediate effect on the relevant items making some worse off and some better off. • But price sensitive information relating share market was disseminated by NBR, MoF, BB, SEC and so on. These left a huge impact on bubble creation. • Making news such as black money is coming to the market helped speculation.

20. Manipulations won’t be able to inflate the entire market. • Due to manipulation some people might gained • disproportionately from IPO issuance, but they are not likely to contribute to the bubble substantially. • Link between primary and secondary market prices • If a primary market price is fixed at a higher level through • manipulation or corruption then the relevant question is: • will the price survive in the secondary market? Manipulation in Primary market

21. Cont------ • Whatever prices are fixed at the primary market the • secondary market price of that item will be realized through • secondary market demand. • Comparing with comparables. How? • JK Spinning EPS= Tk 2.00 Textile sector PE ratio 40 • Premium Tk.90.00 primary price= Tk 100.00 • Secondary mkt price close to Tk 80.00 • High premium may create expectation of high price in the • Secondary mkt and thus comparing with better companies in that sector. • Immediate pricing may be affected but come close to others in the medium term. Also Fund diversion.

22. Switching to secondary Mkt • Increase in the primary prices hurt the intermediaries who • benefit from bringing the primary shares to the secondary • market. • During initial inflated secondary prices investors flocked to • the primary market to gain from IPO. • The manipulation leading to higher primary prices and • many more applicants attracted by initial big margins pushed • the expected gain down. • As result, many moved to secondary market fueling the • secondary market inflation.

23. Taking advantage of the placement shares has implication • for gains distribution but bringing primary shares through • proper or improper procedures makes no big difference in • setting secondary market prices. • Even if there is no book building method (BBM) or no • Premium on IPO there will be a huge increase in index because • inflated secondary market will set a high price for it. • This implies if the secondary market is inflated there will be • rise in index irrespective of its initial price. • BBM • BBM with PE ratio cap of 15 will bring only lemons. • Cap should vary with sectors. More---

24. The conclusion is straight forward: • Do not encourage supply in an inflated market. • If there is a high premium - raise the cost of owning that specific item but the price is set higher not because of premium, just because of high demand. • The claim that charging high premiums was one of the main reasons why there was a bubble -- simply not true. • Indirect inflation through switching may happen Cont…

25. D”| D S B C A O Manipulation in the Secondary market • Husband wife enterprise would not sustain had not there • been enough demand.

26. Cont.. • Their fake price hike would not sustain without excessive • demand. For inflation to come several round of this is needed • But excessive demand without HWE would have ultimately driven the price to the level that HWE set, may be in a little longer duration. • Therefore, it is DEMAND! Real DEMAND!

27. Conclusion on bubble creation • Once there is excessive money in the economy aligning • investment incentives among competing sources is crucial. • The excess supply of fund, created by policy mistakes as • appeared, would not transmit disproportionately to stock • market had there been no substantial distortions in place at • the micro level. • The MoF has created incentives distortion that directed the • excessive supply of money to the share market. • Supply driven policies were entirely wrong. • Instead of demand management, demand was highly • induced.

28. Distortions created through Fiscal & Monetary measures • lowering interest on NSC, • imposing tax on NSC income, • directing black money to share market, • leaving share market income non-taxed, • allowing credit for share purchase and so on. • SEC’s weak and corrupt policies allowed some wrong practices such as • improper IPO issuance, book building methods, • fake statements and asset revaluation, and • information leakages that helped speeding up inflation of the market. • Without inflation at the secondary market created through fund flush most of these manipulations would not have happened.

29. Crash • Ups comes with Down separated by time • Sponsors got away with big sales at inflated prices • Since banks were coming to the market increasingly, fund diversion was not creating downward pressure on demand.

30. Market vs. non-market risk. • The market risk is the risk that the price of a particular stock • will be affected by overall stock market movements. • Non-market or idiosyncratic risk, on the other hand, is • related to the risk that events specific to a company or • its industry will adversely affect the stock's price. • Market risk is unlikely to be controlled by investors but • non-market risk can be reduced through effective • measures such as diversification of the portfolio. • When we talk about risky investment in capital market it is • the second we talked about.

31. Cont… • But the government or the social planner steps in to reduce market risk when it accumulates. • The Government intervention in controlling market risk backfired instead. • The policies undertaken focusing on supply enhancement intensified market risk. • Therefore, complaints against regulatory bodies are kind of not unfair. Their policies aggravated the situation

32. Cont… • When ministers were talking about the market and saying that the market were not overvalued, then the small investors were taking it for granted; and caring only for non-market or idiosyncratic (item specific) risk. • Experts were opining that the market was overheated. When heat was intensifying even further the average investors were trying to choose the optimal time to sell their shares. • They were trying to follow the movement of a dominant player such as banks whose move may signal a large correction.

33. Cont….. • Why banks? • A couple of banks made close to 100% profits. Almost none less than 50%. • Supply-side models argue that GDP growth of the underlying economy flows to shareholders in 3 steps. • First, it transforms into corporate profit growth. • Second, the aggregate earnings growth translates into earnings per share (EPS) growth, and

34. A portion of GDP growth comes from capital increases, • such as ---new share issuances, rights issues, or IPOs, • which increase aggregate earnings but are not accessible to current investors. • This causes the growth in EPS available to current investors to be lower than growth in aggregate earnings. • Finally EPS growth translates into stock price increases • 1+r=(1+grEPS) (1+gPE) • where • r is the price return of the stock, • grEPS is the growth rate in real earnings per share and • gPEis the growth rate in the price-to-earnings ratio. Cont..

35. Cont… • 100% growth of banking profit is a convex combination of low around (6-2+9)or 13% profit from normal operation and a unusually high share market operation profit. • Thus, the move of banking sector was crucial. • Some of the banks invested even more than 10 times of their equity in the share market. • When the BB set a deadline, bank attempted to sell all (use game theoretic explanation). At the same time, the individual and other institutional investors got nervous prompting panic sale.

36. Without panic sale the bubble could sustain for a long period (example US bubble not busting in 72-73 despite having similar index and other fundamentals) • Bought AB bank with the lowest PE ratio, price declining. That’s where the small investors got angry. That’s what brought them to the streets again and again.

37. Actuarially not fair • Only 500 crore black money whitened in that phase--created expectation –flush of white money from different channels– Contributed to bubble creation. • NBR on white money • 121 crore total whitened in last permission – less than 20 crore in share market • 800 crore total whitened during last Caretaker Government • --no sectoral allocation is available. Ideas needed to be included…

38. Cont… • We can show that before black whitening process starts – a flush of white money entered the market induced by black whitening effect on speculation --- As part of the event analysis.