With government economic reforms kicking in, the nation's tiny bourse is outperforming all others - at least for now

Around the world, equity markets are grappling with tough times. Except in Pakistan. Despite jitters over the conflicts in Afghanistan and Iraq to the west and continuing tensions with neighboring India to the east, Pakistan's tiny stock market is scoring record gains. Indeed, Bloomberg ranks the KSE-100, the benchmark Pakistani index, as the world's top-performing stock market. Despite a correction early this year, the index is up 51.4% for the 12-month period that ended on Mar. 31. Barring some sort of political or war-related catastrophe, the market seems poised to continue its steady upswing.

Why the buoyancy, especially as U.S. and Pakistani soldiers conduct raids on suspected terrorist enclaves? Thanks to a series of government reforms, Pakistan's economy is doing amazingly well. Gross domestic product is projected to grow at a solid 4.5% this year. The previously corrupt, inefficient tax-collecting authority, Central Board of Revenue, is being restructured, and for the first time in years, tax-collection revenues match up with target numbers.

Privatization has also begun in earnest and United Bank, the country's third-largest bank, was sold in October for $200 million. In addition, a resumption of post-September 11 aid inflows from the U.S. has strengthened Pakistan's balance of payments and helped boost foreign-exchange reserves to a record $10.3 billion.

STRICTER MEASURES.  Another big plus for the Karachi market is record low interest rates. As the State Bank of Pakistan, the central bank, has driven interest rates down over the last two years, the yield on six-month government treasury bills has declined from 12.5% in July, 2001, to 2% today. By contrast, companies in the KSE pay an average dividend yield of 10%.

As investors seek higher returns, major new liquidity has found its way into the equity market. "Whether its wealthy individuals or big institutions, money is coming in, and there are no other avenues for it to go," says Moin M. Fudda, Managing Director, Karachi Stock Exchange. "That new liquidity is clearly the fundamental reason for the [stock market] rally."

The global crackdown on the hawala system of informal money transfers has also bolstered stocks. Remittances sent by expatriate Pakistanis through banks are expected to hit $4 billion in the fiscal year that ends on June 30, 2003, up from $2.4 billion in the previous fiscal year. And a significant chunk of that is making its way into equity investments.

DON'T "OVERSTRETCH."  Improvements in corporate governance have helped, too. In the last two years, a host of measures enforced by the Securities & Exchange Commission of Pakistan, including requiring listed companies to circulate quarterly reports and penalizing them if shareholder meetings aren't held on time, have enticed more individuals to get involved in the share market.

The KSE also has beefed up its regulatory oversight of brokers. "Ensuring that brokers don't overstretch themselves has given investors comfort and given the market stability," says the KSE's Fudda. Brokers' capital adequacy, which until recently was monitored only on a weekly basis, is now tracked daily, and exposure to trading risks is now calculated hourly rather than daily.

For all the good news, many foreign fund managers are far from impressed. Indeed, they've been markedly absent during the market's historic rally. From July, 2002, to February, 2003, the net inflow of foreign portfolio investment amounted to just $9.4 million. Still, that's quite an improvement from the net outflow of $7.7 million from July, 2001 to February, 2002.

GOING PRIVATE.  The KSE estimates that for all of 2003, net foreign investment could approach $50 million -- the bulk of the money from expatriate Pakistanis. The U.S. and European fund managers who could give the market added credibility outside Pakistan aren't expected to join in, however.

Skeptics fear the market is still open to manipulation by a handful of big speculators. Although the Karachi Stock Exchange has 717 listed companies, only about 30 are easily traded, and the 10 most heavily traded stocks account for 80% of the market's total trading volume. Plus, poor investor awareness and a lack of marketing on the part of brokers means the country has only a tiny base of individual investors. Indeed, Mohammed Sohail, head of research at Capital Securities, a Karachi-based brokerage firm, estimates the number at no more than 100,000.

The government is working to improve liquidity. Under a new privatization strategy, it's selling off its shares of state-controlled companies while listing them on the bourse as well. In last four months, about $70 million worth of stock in three state-owned companies has been sold, and Abdul Hafeez Shaikh, Federal Privatization & Investment Minister, says more will follow. For instance, two state-owned energy companies, Pakistan Petroleum Limited, and Pakistan Oil & Gas Development Corp. are expected to be listed this year.

BIGGER CAP.  For the foreseeable future, the KSE will continue to be overshadowed by neighboring India's $100 billion stock market, a natural choice for investors poking around in South Asia. Pakistan's market capitalization has more than doubled over the past year but is still just $10 billion. Muddassar Malik, director at Karachi-based investment banking firm BMA Capital Management, says to really get noticed the KSE's market cap must expand to the point where it accounts for at least 50% of GDP, up from 11.7% now.

Over the longer term, that certainly seems possible -- if all goes well. But even raging bulls on Pakistan's prospects know that any number of problems could intervene and suddenly slow or halt the market's progress.