Pakistan banks have had a tough 2022, with the economy experiencing significant stress amidst unhelpful politics. Fiscal needs also compelled the government to heavily tax banks, which sharply clipped profitability. The sector has underperformed the KSE100 this year.
The outlook is better. Margins are rising and are expected to be downward sticky. Asset quality is resilient, even with the floods, and while the regulatory climate is tighter, it is in the price. The recently resumed IMF programme can help stabilize the economy.
Valuations are already much below what would normally be called cyclical troughs, and have significant room to rerate as ROE lifts. Valuation mean reversion implies upsides of up to 50%, not taking dividend yield into account. Our top picks are UBL (high c 20% D/Y), BAFL (strong growth prospects) and MEBL (best-in-class).
Margin expansion can be downward sticky
The Policy Rate has risen by 525bps in 1H 2022, and 800bps since September 2021, to 15.0%. This is helping lift margins, a trend which should continue across the balance of 2022f and into 2023f, even if further monetary tightening does not take place. Impetus is coming from marked success in improving the deposit mix, well-positioned investment books, and strong loan growth as banks push up ADR levels. We see NIMs expanding by 70bps to 4.6% in 2022f, and then by another 60bps to 5.3% in 2023f. Importantly, margins may be downward sticky when the interest rate cycle eventually turns, helped by the higher proportion of current accounts in the deposit mix (40% in June 2022 vs. 38% in June 2021).
Asset quality is resilient; floods may not be a major threat
Pakistan is in the grip of steep inflation, expected to average c 20% this fiscal, with macroeconomic stress to be exacerbated by the worst flooding since 2010. Inflation may touch 30% in the next few months, cotton imports will widen the current account deficit, and rehabilitation efforts will test the fiscal side. These pressures are expected to be transitory, however, and should not have a material impact on asset quality going by 2010’s precedence. That said, we still prudently raise our cost of risk for 2022/23f to about 50bps, up from 30/40bps previously, given the high inflation backdrop. Our cross-cycle estimates for cost of risk remain largely unchanged, with the resumption of the IMF programme and higher provisioning coverage of 100% providing comfort.
Regulations moving towards international best practices
Banks have had to contend with sharply higher taxation in 2022, and the government’s weak fiscal footing means this could be an ongoing concern. We incorporate a higher recurring tax rate of 43% for banks (39% income tax + 4% super tax). The next two key checkpoints for asset quality are IFRS 9 adoption from 2023f, and writing-off fully provided bad loans by June 2023 (new IMF structural benchmark for Pakistan). Implementation of the Single Treasury Account is also underway, although most private sector banks should not be affected too much. In general, capital ratios for the sector are robust enough to absorb the impact of these changes, but we believe it is possible that the SBP looks to spread the initial impact of IFRS 9 over several years. HBL may need to issue an ADT-1 instrument and MCB may have to gradually shift to a more sustainable cash payout ratio, down from 80%+ at present.
Valuations are highly compelling
Banks have underperformed the KSE100 this year, but we believe they will be one of the main sectors to lead the market’s rebound, as the economy stabilizes. We expect ROE for our banks universe to rebound from 16% in 2021 to 23% in 2023f (peak margins), before settling at 18% mid-cycle (2026f). Valuations are at troughs, where our coverage cluster trades at a 36% discount to 5yr P/B and a 58% discount to 5yr P/E. HBL and BAHL appear to have the most upside on valuation mean reversion, while the likes of UBL, MCB and BAFL offer excellent dividend yields. Risks, including those emanating from a tighter regulatory environment, appear adequately priced in already.