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Notes from Islamabad

By September 9, 2019 No Comments

Dear Friends,

I am in Islamabad this week. The general feeling I get is that the mood slowly is improving. Getting the economy back on track looks like the top priority for the government and all hands are on deck for it. Another good sign is that there seems to be high level of coordination and communication between the various government bodies. As I wrote in my last blog, even the army seems to be concerned and involved in economic affairs. Someone referred this to a state of “economic emergency”. I hope they can use this impetus to sustain the reforms and push them through the bureaucratic red tape.

According to my opinion, the message going out seems to be that interest rates will come down by the end of the year, exchange rate will remain stable, exports will continue to accelerate and inflation will taper off. The impact of these messages is visible in the money and FX market. For example, the inter-market exchange rate for PkR/USD is now lower than the official rate – a very rare occurrence and in the past week, the rates on 10 year PIB have slid from more than 14% to 12.5%. In the equities market, the net flows still are negative but there is a sharp pick up in insider buying and individuals continue to accumulate.

In my opinion it is imperative now that the government comes full on the promises it is making. Sentiment is a fickle thing and markets run on credibility and perceptions. If the government fails to deliver on any of the key messages, i.e. lower interest rates, lower inflation and most importantly stable exchange rate, it could do more long term damage. The handling of the GIDC case is a bad example.

The primary attention of the government seems to be the on bond side. The Governor State Bank seems particularly keen to replicate the success of Egypt, which attracted $20bn of inflows in their local currency bond market. Local currency yields are attractive but the major hurdle is taxation. Asides the cost, the administrative hassle associated with creates a significance nuisance value.

The primary concern on the macro side is the slippage on meeting the fiscal targets. The government has clarified that the recent miss (8.9% fiscal deficit versus 7.2% target) was due to delays in collecting the payments from telecom operators, lower tax collection from imports and their decision to not to pass on the complete impact of higher international oil prices. Last month the telecom operators paid $224.6m to renew their licenses. This was a one-off payment and I don’t think it will be sufficient to alleviate the concerns. The revenue targets always seemed very ambitious.

The fear is that the government will have to hike GST and utility tariffs in order to meet the revenue targets. This will feed into higher inflation and put pressure on the interest rates. The exchange rate could also become volatile, especially around the dates when foreign payments are due. The other risk is from the second round impact of a tough austerity program. The case of Argentina is a good example. Argentina defaulted despite of receiving a $50bn bailout from the Fund, as the reform measures proved too difficult politically and led to a change in the government.

The steep rally in the market in the third week of August indicated that there is capital on the sides waiting for any signs of a sustained turnaround. Given the high levels of short interest, even a marginal shift in sentiment can lead to a big swing. Unfortunately, the market support fund which was announced by the government failed to materialize. I think that was quite a good idea and the signal that the government is willing to support asset prices could have given confidence to the market. Paradoxically, instead the government has now announced the intention to sell 8-10% of OGDC and PPL in the market. This is exactly the opposite of what a rational investor, albeit one with a positive view on the market will do. Instead of selling stock of state owned companies at low valuation, the government should do a buyback. Otherwise it sends a signal that it feels that the price levels are fair. Their current multiple of 4x PE is more than 50% lower than their historical average and looks more distressed than a fair level.

Last week, I read Goldman Sachs famous N11 report in which they had identified 11 countries which could be the next emerging markets. Pakistan was in this list. The report was published in 2005. My friend, Dr. Salman Ahmad was a part of the Goldman team who wrote the report. Dr Salman now runs investment strategy for a leading Swiss private bank and is a highly regarded commentator on the global capital markets. Pakistan was ranked 4th in that group in terms of GDP and was ranked number 10 on the Growth Environment Score (GES). The other ten countries in the list were Korea, Mexico, Turkey, Indonesia, Iran, Nigeria, Philippines, Egypt, Bangladesh and Nigeria.The report expected Pakistan’s GDP to grow by 5% annually over 2007-2025 and reach $359bn by 2025 ($1,568 per capita). The performance of Pakistan over the past 13 years has been slightly better than expected.

GDP growth has averaged 5.6% during this period (in dollar terms) despite of the recent exchange rate depreciation. GDP per capita last year was $1,238. This performance is quite encouraging, especially in the back drop of the economic cyclical downturns in 2008, and 2013, and the exchange rate devaluation of last year. However, the market trades at a massive discount to most of the peers in N11, except for Iran.

I think the most positive factor for Pakistan macro is the alignment between the army and the political government. The structural reforms required by the Fund will be politically painful. They have already consumed the first year of Imran Khan’s government and are likely to persist for another 12 months. The government will need massive support from other institutions including media and bureaucracy to implement the plan.

Pakistan government must be counting on improved relationship with the US for getting some leverage on FATF and a more tolerant IMF. Today’s setback in the peace talks in Afghanistan is a negative development in this regard. Longer term, the only way Pakistan can get out of this geo-political-economic trap is by encouraging private investment, both local and international. Successful management and execution of the privatization road-map might be crucial.

I am, yours truly,

Ali Farid Khwaja

Managing Director
K
hadim Ali Shah Bukhari Securities

* This is not research material and there is no investment recommendation in this blog. These are my personal views. 

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