The market is growing upMargin trading is a welcome development, but it is no panacea for stock doldrums.
As part of the evolution of Nepal’s nascent stock market, the introduction late September of margin trading should be viewed as a welcome development. For over three years now, the Nepal Stock Exchange (NEPSE) has been caught in a downdraft. Investors had been clamouring for margin trading, hoping this would help reverse the downtrend. Apparently, the response to date has been lukewarm, which is not surprising given that it has been around for only a few weeks. Because margin trading is a new tool, most investors are probably not aware what it entails or even how to deploy this—if at all—in their investment portfolio. The way it is being bandied about is that margin trading is good for stocks. This is not untrue, but there is another side to the story, which is that margin trading cuts both ways.
In a cash account, customers pay the full amount for the stocks they buy. In a margin account, brokers lend clients money to buy stocks, using their account as collateral. Interest will be charged on the loaned amount. Clients, in essence, borrow against their deposited cash or invested equity to purchase marginable securities. Let us say an individual purchases Rs100,000 worth of stock using Rs50,000 borrowed and Rs50,000 in cash. If the stock rises 20 percent to Rs120,000, his/her equity increases from Rs50,000 to Rs70,000, for a 40 percent increase. In contrast, if he/she only used cash for the purpose, his/her equity goes up 20 percent from Rs50,000 to Rs60,000. In a bull market, leverage can do wonders. But markets do not always go up. They go down as well. In a down market, losses get exacerbated quickly in a margin account.
Leverage cuts both ways
Currently, 21 of the 50 brokers in Nepal are allowed to issue margin loans. They can issue loans of up to 50 percent of the value of the shares based on the 180-day average price or the prevailing market price, whichever is lower. The 50 percent initial margin means clients must come up with at least half the cash for a purchase. Not all NEPSE-traded stocks are marginable. To be eligible, companies must have issued a minimum 10 percent dividend in the last two years and have more than 10,000 shareholders, among others. If the value of investment in a margin account goes down, the broker may require the client to post additional capital. The maintenance margin is set at 40 percent. Once the value drops below this threshold, the broker will issue a margin call, which will have to be met within a stipulated time. Inability to do so gives the broker the right to liquidate some, or all, of the holdings. This is where it gets risky.
In the developed markets, margin debt is used as a tool to gauge investor sentiment, which routinely swings from euphoric to panicky. In good times, investors are in a mood to take on risk. This leads to a period of exuberance, which then makes way for bad times when these excesses get unwound. In many respects, Nepal is a different market—and understandably so. The history of the stock market is only a quarter-century old. The NEPSE opened its trading floor on January 13, 1994. Currently, there are 217 companies listed. The index is inordinately dominated by financials. By mid-September, the share of banks and financial institutions plus insurance companies in the total market cap was 78.4 percent, with hydropower the next highest at a paltry 6.5 percent. This is too lopsided and is a sign of an immature market. Despite this, fear and greed play as important a role in the decision-making process of a Nepali investor as any other investor in the world.
In July 2016, the NEPSE reached a record high 1888. By March this year, it had collapsed to 1099. Rally attempts have been repeatedly sold. As recently as May this year, the index tagged 1349. Currently hovering in the 1150s, it has essentially gone sideways for four years. Hence the investor frustration, and also the search for a catalyst to push the market higher. In a way, the prevailing frustration is understandable. In recent years, things are stable politically. Growth has shifted into higher gear, with the gross domestic product expanding at a 7.1 percent rate in the fiscal year 2018-19 (through mid-July this year), and at 6.7 percent and 8.2 percent before that. Nepal Rastra Bank has switched to an expansionary monetary policy. In the first two months of the current fiscal through mid-September, liquidity expanded 15.4 percent year-over-year.
Yet, the market is stuck in a rut. For every high, there is a low. For pessimists, there is no shortage of issues to gripe about. Banks cannot keep up with the demand for loans, but deposits are not keeping pace. In the first quarter of the current fiscal, banks extended Rs141 billion in loans against deposits of Rs106 billion. The resulting higher interest rates reduce the present value of future cash flows of companies. Consumer inflation has perked up, with the first two months of the current fiscal through mid-September rising 6.2 percent year-over-year; this pushes up the discount rate as well. Last but not the least, plenty of money that could potentially have gone toward the stock market is stuck in real estate, which remains elevated and, maybe because of this, is also seeing fewer transactions.
Shorting can fill the vacuum
In this environment, provided it catches the public’s fancy, margin debt can provide a temporary boost to stocks. The danger in this is that, as things stand, it only puts upward pressure on stocks, potentially throwing matters out of balance. Shorting can provide an antidote. In a margin account, customers can short stocks, as well as trade futures and options. None of these three tools are currently available in Nepal. In short selling, a customer sells borrowed shares and tries to buy them back at a lower price before returning the borrowed shares. In this setting, longs who indulge in margin trading expecting higher prices will be pitted against shorts who are betting on lower prices. Ideally, this pull-push is what makes a market. After the introduction of margin trading, shorting should act as another stepping stone to gaining maturity.
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