Our views on Pakistan’s economy and market
We think the market could rally once there is greater clarity on the political front and on the status of the decision of the Financial Action Task Force (FATF).
The date for the elections has been announced (25th July). In our view, the consensus opinion seems to be that the most market friendly political outcome could be a PTI led coalition government with the support of PPP. Markets like certainty and consequently an alignment of the “establishment” with the government should move things back to normal. Also, a PTI government could give more confidence for Pakistani diaspora to re-invest in Pakistan and could lead to a positive sentiment shift. Any political confrontation with Nawaz Sharif is the main risk.
The other key risk (besides the balance of payments situation) is the outcome of the FATF review. The next meeting of the FAFT is scheduled for 24th of June in Paris. In the last meeting of 22nd February, Pakistan was given time to present a plan of how will it implement policies to deal with the shortcomings on money laundering and terrorism financing. Pakistan will present its case in the meeting. If the plan is considered to be appropriate, then Pakistan will be placed on the “watchlist” or the grey list. In case, the proposal put forward is deemed to be insufficient, the country could face black listing. Click here for an excellent article by international law expert Taimur Malik.
The Financial Action Task Force is an inter-governmental organization, set up in 1989 which has 35 members. Pakistan is an associate member of the Asia Pacific Group on Money Laundering. FATF cannot put direct penalties on Pakistan, since Pakistan is not a full member. Instead, its assessments have an indirect impact as financial institutions such as World Bank rely on it for credit assessment. A blacklisting could prevent the World Bank from issuing a letter of comfort, which would block funding from IMF and other bodies such as the ADB.
The grey list per-se does not carry strong penalties. It essentially means that the FATF agrees to the plan and will monitor if the plan is being implemented. Pakistan was on the watchlist between 2012-2015 and there was no noticeable negative impact on growth, foreign investments or the stock market performance during this period. Ofcourse KSE-100 had a very strong bull run over these years and many global funds entered the market. We think most institutional investors are insensitive to the assessment of FATF. However, there could be a negative impact on the banking sector.
We spoke to a friend who is the head of compliance of a mid market US bank. In his opinion, his institution deems the countries on the watch list to be “high risk” and requires greater due diligence and a board approval for opening any new business relationship for companies from such countries. While this could lead to greater friction, especially in areas such as correspondent banking and trade finance, we do not expect it to have a significant and material impact. However, the black list would certainly make things more difficult.
There are multiple potential scenarios which are worth considering.
Scenario 1: Worse case outcome – FATF becomes a proxy for the US versus CPEC
There is one school of thought under which its believed that the threat of the black list, along with recent fine on HBL in the US are a part of a greater strategy of the US government, in line with President Trump’s “Art of the Deal”. The US wants to pressurize Pakistan to rollback on CPEC. However, faced with this choice, Pakistan could chose to side with China. If this happens then, the US could “punish” by using its influence in the FATF to put Pakistan on the blacklist. If this happens, then the World Bank will also not issue letter of comfort and the IMF and ADB programs will also stop. In this scenario, the only economic option would be some kind of bailout from China.
Although this view has quite a large fan following but it has a lot of gaps. Firstly, as can be seen from the fallout from Iran sanctions, we do not think even the US has unilateral powers to make other members put extreme actions. Secondly, it is worth remembering that even China also eventually did not vote in Pakistan’s support in the last meeting – so it might be irrational to expect such kind of support. Third, it could be difficult for the FATF to place Pakistan on the blacklist when the country is willing to show intent and take actions to implement its recommendations. Lastly, we doubt that the US would want the relationships to reach a point of no return. Clearly the threat will lose its bite under such an outcome.
Our probability to this scenario: 5%
Scenario 2: Pakistan goes on the grey list and enters the IMF program
We think this is the more likely scenario. According to our channel checks the government machinery including the SBP has been quite proactive to address the concerns of the FATF. We expect the FATF to accept the proposals and to place Pakistan on the watch list to give it time to implement the plan. The FATF will monitor the progress (via World Bank) and if there is inadequate implementation then there would be the threat of blacklisting. Strategically, it works better for the US to keep the stick as a threat, than to yield it. Under this scenario, we expect the FATF decision by end of June, a new government in July and an IMF program by the end of the year. We think the markets will rally but would be volatile until the external financing situation is resolved. IMF would probably require a cut in fiscal spending, rise in interest rates and exchange rate depreciation. Export driven sectors such as technology (Netsol, Systems) and textiles (Nishat Mills, Kohinoor textile mills, Nishat Chunian) and companies whose earnings are linked with the USD such as in energy should outperform in this scenario.
Our probability to this scenario: 70%
Scenario 3: Best case scenario – FATF grey list and Chinese funding
This is the wishful scenario which most Pakistan bulls desire; a less punitive outcome from the FATF and funding from China. In the last fiscal year (june end), Pakistan took $5bn in loans from China and Chinese banks (click here). In April, Chinese bank provided an additional $1bn in funding. There have been recent cases, where the Chinese banks, according to press, insisted on providing complete funding, rather than involving any other third party (click here). There also has been precedents from Venezuela (click here), which was given $50bn in loans by China over the last 10 years (Venezuela is not an enviable example). After all, China itself has $28 trillion of debt, which is more than 230% of its GDP. If the OBR and CPEC is so strategically important, then providing financing for the development of this infrastructure should not be an issue (in fact, commercially, it should be very attractive lending for the Chinese bank). If this scenario plays out, we expect a strong rally in the markets in the second half of the year, driven by banks, steel, energy and cements.
Our probability to this scenario: 60%
In terms of timing, there should be more certainty around all of this issues by the end of July.
We think foreign investor’s sentiment on Pakistan might be close to a bottom. In the equity markets there have been outflows for the past few months. As our sales colleague Kamlaish Kumar published in his Sales blog (you need to be on his list), Franklin Templeton, mentioned Pakistan’s macro risks in its April EM blog (click here). Some of the outflows might be driven by such concerns. The sentiment has been worse on the bond markets, where the yields on Pakistan bonds have widened above countries such as Gabon, Ethopia and Greece. Here are some interesting charts (courtesy of a friend who is an Economist at a leading Russian bank).
According to press, the primary concern of the FATF is around freezing the accounts of certain organizations which have been declared as terrorist organizations by the UN (Click here). We expect the FATF pressure to make the government take action against all such organizations, which indeed will be very positive development for Pakistan’s own interest in over the long term.
As a market strategy, we recommend our clients to keep liquidity to start building positions in the market over the next 3 months. Valuations have started to look very attractive especially in sectors such as autos, cement and energy, where many high quality companies are now trading at or below book values.
I will be in Karachi over the next couple of weeks and will be meeting clients. Please let me or Kamlaish know if you or your institution wants to have a meeting (Email here).
I am, yours truly,
Ali Farid Khwaja, CFA
Khadim Ali Shah Bukhari Securities
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