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.
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.
Problems with the policy suggestions
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.
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
Created imbalance centering Share Market
Table 1a: Movement of Index and PE
Ratio over time
2003
2004
2005
2006
2007
2008
2009
20102010 06
968
1971
1694
1610
3017
2795
4536
8290
6343
8.44
18.4
14.03
14.51
23.58
18.42
25.65
29.16
24.55
• 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
Explaining the paradox
Table 1b: Change of PE Ratio between 2007 and June, 2010
2007
Bank
24.97
Cement
12.61
Ceramic
29.85
Engineering
28.57
Food & Allied
23.95
Insurance
15.59
Investment
20.29
IT
15.25
Jute
7.98
Miscellaneous
14.43
Paper & Printing
6.23
Pharmaceuticals
21.05
Service & real estate
8.82
Tannery
15.38
Textile
12.14
2010
16.07
29.98
121.16
53.6
21.55
38.4
62.24
44.34
19.39
28.07
31.95
53.59
18.56
38.19
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.
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.
Continued------------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.
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
Failure to recognize that
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.
Continued ----S
S
S’
S
D
S’
D
D
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
S’
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
The jump in index in 2009
DSE Performance: January 2009 to December 2009
Month
Jan-09
Feb-09
Mar-09
Apr-09
May-09
Jun-09
Jul-09
Aug-09
Sep-09
Oct-09
Nov-09
Dec-09
DGEN
2,649.49
2,570.96
2,446.92
2,554.36
2,572.18
3,010.26
2,914.53
2,941.28
3,083.89
3,364.26
4,380.95
4,535.53
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.
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.
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.
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.
Manipulation in Primary market
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?
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.
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.
More--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.
Cont…
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
Manipulation in the Secondary market
D”|
D
B
S
C
A
O
Husband wife enterprise would not sustain had not there
been enough demand.
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!
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.
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
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.
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.
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
enhancement intensified market risk.
on
supply
Therefore, complaints against regulatory bodies are
kind of not unfair. Their policies aggravated the situation
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 nonmarket 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.
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
Cont..
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
g is the growth rate in the price-to-earnings ratio.
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.
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.
Ideas needed to be included…
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.
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.