In search of a cure for the capital market

While towns and cities in Bangladesh are struck by the Cricket World Cup fever, the current roller-coaster ride of the Dhaka Stock Exchange (DSE) is still causing panic among retail investors. Investors have resorted to even organising prayers and 'milads' seeking devine intervention. As shell-shocked investors are still licking their financial and physical wounds, policy-makers are scratching their heads to avoid repetition of similar episodes in the future. While investors would be naïve to expect a "quick fix" formula from anyone including the government, Bangladesh Bank, the Securities and Exchange Commission (SEC), the Dhaka Stock Exchange (DSE) or the Chittagong Stock Exchange (CSE), important lessons are to be learnt from the current crisis. This article highlights some of the measures that need to be taken for the long-term stability of the capital markets in Bangladesh and future growth prospects of the Bangladesh economy. In a market economy, the capital market plays a vital role in the efficient allocation of scarce resources. Well-functioning capital markets play an important role in mobilizing savings and investments for organizing the production of goods and services, creating jobs, and enhancing economic development. There is a saying that the stock market is the pulse of the economy. In the developed Western world, how the stock market is doing is not only a matter for prime-time news bulletin but also a matter of public interest on an hourly-basis. Keeping conspiracy theory aside, instability or extreme volatility of a capital market may suggest weaknesses in the market. Further, this is an indicator of looming economic uncertainty. If we look at history, all economic catastrophes were accompanied by stock market melt-downs. A common misconception in Bangladesh is that the government alone has the power or ability to control or fix anything including the stock market. While the economic policies of the government and overall management of the country will set the tone for the stock market and influence the overall attractiveness of stocks as a form of investment, the government is in no position to control or dictate the day-to-day price movements of stocks. Day-to-day price movements of a specific stock or share are determined by the aggregate demand for and supply of that stock. Based on the information-set available for particular stocks, investors more or less form some opinion on the "value" of those stocks. These opinions are reflected in the aggregate demand and supply forces for those stocks. Neither the government nor the DSE can control how individual investors process the information-set available for individual stocks, and how investors value those stocks. Trading in a stock market is not a synchronized swimming event. Therefore, no group of investors can blame others for suffering financial losses. This is the nature of the beast. In a capital market, virtually every investor, regardless of size, shape, and expertise, is competing with all other investors. This is so because trading takes place only when two investors take exactly the opposite positions on a share or stock (one willing to buy, one willing to sell). No wonder such a process would be fraught with dangers and pitfalls for the uninformed, unsuspecting, small players. Three foundation stones of a strong capital market are strong investor protection, investor education, and transparency of information. Arguably, investor protection is very weak in Bangladesh. One needs to look no further beyond the culture of defaulting on bank loans. Besides, high crime rates, slow judicial process, lack of people's confidence in law enforcement agencies, general lack of accountability in the society, and weak corporate governance structure make Bangladesh a country of weak investor protection. The level of investor education is very low in Bangladesh due to several reasons. First, the literacy rate is very low. Second, financial literacy within the educated class is primarily restricted to business and economics graduates. If investors do not have even some broad knowledge of how stock prices are determined, what the fundamental drivers of firm value are, and have some kind of idea on whether or not a particular stock is over-valued, investors' trading behaviour will lack any economic sense. Everyone knows what it is like driving a motor vehicle without knowing road rules or not being able to read road signs. Investors, having no financial literacy, are just like blind drivers on the road, and simply riding on their luck. For these investors, a volatile stock market is like a mine-field. Despite being a people's republic, Bangladesh has a deep-rooted history of being a hierarchical society with large power distance. In Bangladesh, economic and social position of familial ancestry still plays an important role not only in marriages and relationships, but also in jobs, positions, power and politics. Societies with large power distances are societies where the rich and powerful in the society use their information advantage against the weak, the poor, and the uninformed. In these societies, information does not flow freely. Such a society is very secretive, and secrecy of information and not sharing the information with others are the ways the informed insiders maintain their position and power. Bangladesh is a country where information does not flow freely and smoothly. Without free-flow of information, the stock market cannot function efficiently. When market participants are forced to make a decision without adequate information, such decisions are likely to be wrong and not in the best interest of the decision maker. During our undergraduate years, when we used to approach companies for their annual reports or audited financial statements, routinely we were told that releasing financial information (statements) to us (students) would require permission from the "Bara Shaheb" or the Managing Director. Companies in Bangladesh are very good in hiding information about them. Several months ago, I went to the Bangladesh Biman website and made a request for a soft copy of its published annual report and I explained the reason for my request. I am still waiting to get a response. This is the information culture in Bangladesh. In the developed world, one can just anonymously download company financial reports and other corporate disclosures from company websites. In developed capital markets, posting of annual reports on the company website is just a routine affair. In my view, for the development and long-term stability of the capital markets in Bangladesh, the following measures are imperative. First, to improve informational efficiency of capital markets, Bangladesh stock exchanges should adopt a continuous disclosure regime. Research evidence suggests that in the presence of information asymmetry in any transaction, insiders make economic gains at the expense of outsiders by using their superior knowledge and information. Thus, in a capital market environment, this translates into large, institutional buyers trading against uninformed small investors. To protect the small investors, regulators should adopt a policy of continuous disclosure from the listed companies. In a continuous disclosure regime, listed companies are required to disclose any material and price-sensitive information as and when it becomes available to the company management. If the price for a particular stock moves up or down dramatically, trading can be halted and the issuing company can be asked to provide any information, reason or explanation it may have. Research evidence also suggests that making disclosure only through selective channels can also create information asymmetry. Thus, disclosure must be made as widely as possible so that new information travels to small and weakest market participants no later than it is available to large, institutional investors. Second, to improve transparency of trading, all trading by senior company management personnel must be disclosed via DSE and SEC websites so that investors can re-assess the risk-return characteristics of the firms involved. Further, there should be a black-out period of at least several weeks for board directors and senior managers for major company announcements and announcement of annual earnings. This measure will minimize insider-trading and make the market more efficient. Similarly, if a single trade exceeds certain threshold level (say, 5.0 per cent of issued shares), that trade must be disclosed to the market. If a certain investor and its controlled entities continue to trade in a particular stock in a short span of time (say, two weeks), all these trades must be disclosed to the market. All these measures will curb insider-trading and any conspiracy by so-called 'syndicates' to manipulate stock prices. Third, for an efficient capital market, investor sophistication is essential. By sophistication, I mean the vast majority of investors must know what they are doing. To achieve this, investor education is essential. In a healthy growing economy, an investor on the average will make money simply on a buy and hold strategy. However, this strategy will not work in volatile market conditions. Hence, investors need to be educated on the risks, and challenges of share trading. They must be educated on the link between business activities, firm performance, and firm value. In order to facilitate informed trading, investors need to be able to read, understand, and analyse financial statements. For example, what per cent of active investors in Bangladesh realise that reported earnings are a joint product of the accounting policy choices and firms' economic decisions? What per cent of investors are aware that managers have significant discretion over the accounting policies they can legitimately choose to adopt in preparing financial statements, and how managements' estimates and judgments can affect reported earnings? Without adequate tools for making informed choices, active investors might be just following the band-wagon, gossips, and rumours which can all be irrational trading behaviour. Both the SEC and DSE can take active roles in promoting investor education. Reports suggest that before the recent price collapses, some stocks were selling at price-earnings ratios of 70 to 80 times. How many investors realise the implications of this? Did the firms with such high price-earnings ratios get hold of Aladdin's magic lamp? Fourth, in all developed capital markets, (the free flow of) information plays a fundamental role in making the market efficient. Research evidence suggests that the business press plays an important role as an intermediary in this process. Arguably, business reporting in Bangladesh is still at its infancy. Business sections of the newspapers are thin; business reports are cursory, and lack depth or analysis. This is a result of many factors including skill shortage. To improve the situation, we need journalists with business reporting specialization or business graduates with training in journalism. Business journalists have a responsibility to gather, analyse, and report in-depth business news at the industry level and the company level. In all developed countries, students can do double-degrees or choose double majors such as journalism and commercebusiness. These graduates have the skills of both journalists and business analysts. This is seriously lacking in Bangladesh. Similarly, listed companies opening up themselves to the media can gain in achieving better values for their stocks as empirical evidence suggests that better performing firms make greater and better voluntary disclosures. Firms' competition to catch investors' attention by making better and greater voluntary disclosures can in aggregate make the market more efficient and well-functioning. Certainly, adopting all these measures and implementing them successfully will take some time, but the process can be started right now in the interest of developing strong capital markets in Bangladesh. Dr Reza Monem is an associate professor of accounting at Griffith University, Australia. Views expressed in this article are entirely his own. He can be reached at e-mail: r.monem@griffith.edu.au