It is tricky being a budding capital market. It has its share of advantages and disadvantages. Growing pains are plenty. You learn by doing and by falling over, as Richard Branson once said. At the same time, those willing to learn from others’ mistakes will have plenty of opportunities to do so. Markets that are mature today at some point in time were taking baby steps themselves, going through the pain of trial and error. Their adverse experiences, and how they overcame them, can save the future generation from making the same mistakes. Nepal’s stock market is young. The Nepal Stock Exchange (NEPSE) opened for trading in January 1994, and has a long way to go before it joins the big leagues.

NEPSE began its life listing just over 60 companies. Now, they number around 222. Its market cap has gone from millions to trillions. There are 2.2 million broker accounts, with 70,000 to 80,000 of them active daily; online accounts total 725,000. But the market is not evenly distributed. Banks and insurance companies account for more than two-thirds of NEPSE’s market cap; hydro makes up another 9 percent. That is three-fourths of the market right there. For instance, the likes of Ncell, the leading mobile service provider in Nepal, does not yet deem it necessary to get listed. The sooner NEPSE—or the Securities Board of Nepal (SEBON), which regulates the securities markets in Nepal—can change this, the better it is for the overall investing environment. It can be a win-win situation for all parties concerned. The public can diversify assets into leading domestic companies, and the latter will have wider access to the capital markets.

Give regulators a break

In a budding market like Nepal’s, it is easy to point fingers at the regulators. The internet has made the world smaller and made information easily available. It is easy to complain by comparing what investing tools are available here with those in more mature markets. In Nepal’s case, even the most basic tools are lacking. This is a valid criticism. For all intents and purposes, one can only go long currently. Shorting, in which borrowed shares are sold hoping to buy them back later at a lower price, is not allowed. But giving policymakers credit where it is due, these things do take time. The goal should always be to do it right and with foresight than to do it with haste and without adequate preparations.

In a balanced market, both sides—bulls and bears—should have access to tools to express their bias. It is not the job of regulators to decide—or wish—if markets should go up or down. That should rest with market participants—the so-called collective wisdom. In any given asset, sometimes longs are right, some other times shorts. As a matter of fact, there are times when a short squeeze ends up helping the longs; this occurs when overzealous shorts are caught wrong-footed and forced to cover, putting upward pressure on prices. In Nepal’s perspective, the next step to maturity is to broaden investors’ tool kit with options and futures. SEBON, in fact, is getting ready to award a licence for commodity exchange.

It is never a good idea to only have an upward bias. Devoid of tools such as shorting, that is the case in Nepal’s stock market. NEPSE bottomed in March 2019 at 1099; last month, it ticked 3063. Margin debt has provided a sustained tailwind for the bull market. Unlike cash accounts, margin accounts let customers borrow capital against their cash deposits or invested equity. As of mid-June, banks and financial institutions—27 commercial banks, 18 development banks and 20 finance companies—had issued Rs94.6 billion in margin loans, up from Rs45.4 billion as of mid-July 2019. Brokers have not had much success with these loans as they charge higher rates; SEBON should allow parties with deeper pockets to enter the market.

Learning from others’ mistakes

Banks have been aggressively expanding their margin loan book as loan demand in other sectors of the economy has softened. Plus, unless stocks crash, margin loans issued using stocks as collateral are considered safe in that they can be liquidated quickly. For borrowers, the advantage is that they can borrow on margin, which boosts purchasing power. The disadvantage is exactly that—that they can borrow on margin. Leverage will help in an uptrend, but hurt in a downtrend. As the value of the portfolio drops below a certain level, the lender will issue a margin call, requiring the borrower to either come up with more cash or sell the securities. Inability to do so will give the bank the right to liquidate some, or all, of the securities.

NEPSE has come under pressure since peaking last month, dropping 9 percent in the next couple of weeks. It is too soon to say if the unwinding of margin loans played a role in this. We will find out when mid-July numbers are reported. In a large scheme of things, margin debt looks manageable, comprising around 2.3 percent each of banks and financial institutions’ total loans and NEPSE’s market cap. However, it is tough to get a true handle on the extent of leverage in the stock market, as investors could easily be also using overdrafts and personal loans. The rise in margin debt is a signal that investors’ risk appetite has gone up. This is what a bull market typically does.

In mature markets, as margin debt rises, there is a concurrent increase in other risk metrics; issuance of corporate debt, for instance, jumps as well—particularly low-quality. In Nepal, post-pandemic, loan demand was adversely impacted, and the economy tanked, which in fact pushed more people into stocks. This likely led to over-reliance on leverage. The risk is when the cycle turns. We have seen this saga repeat many times in mature markets. Margin debt, without doubt, should have a place in investing. But equally important are tools to allow the other side to place bets. The way it is set up currently, other than to sell and go into cash, bears are unable to express their bias—either through options, futures or shorting. This creates an imbalance.

Pandey talks markets, money and macroeconomics on hedgopia.com.