The State Bank of Pakistan (SBP) reduced the policy rate by 75bps from 13.25% to 12.50% in the March 2020 monetary policy. This is the first rate cut by the SBP since May 2016, and follows cumulative monetary tightening of 750bps since January 2018.
The key considerations behind the cut were: (i) a substantial improvement in inflation recently (softening food prices in particular) and expectations of greater disinflation ahead due to the downtrend in global commodity prices, (ii) a 72% yoy reduction in the current account deficit in 8MFY20 and adequate improvement in the fiscal deficit, and (iii) perhaps most importantly, the coronavirus pandemic, which threatens to reduce both domestic consumer demand and external demand for Pakistan’s exports.
Even though the decrease was greater than the market consensus of 50bps, some market participants were expecting a more aggressive move by the central bank to address economic headwinds due to the coronavirus outbreak (in concert with some major central banks globally). By not doing so, we think the central bank has refrained from giving into market hysteria and has preserved its credibility.
Nonetheless, the SBP is cognizant that the situation is very fluid, and it may be required to do more in future to mitigate economic headwinds and stabilize market volatility. It reassured that it stands ready to ramp up monetary stimulus if needed. This may help assuage an anticipated initial disappointed reaction by the equity market.
On the threat of foreign money outflow from government securities amidst the global risk-off sentiment, the SBP drew attention to effective foreign reserves buffer of over US$10bn which can withstand any outflow and contain exchange rate volatility. Importantly, the SBP also remarked that it estimates the positive effects of lower oil prices to outweigh trimmed exports and remittances, even in a bear case scenario of a prolonged coronavirus outbreak.
The SBP complemented the rate cut with a (i) new temporary refinancing facility (TERF) – cumulative PKR100bn of loans at 7% fixed rate (10yr tenure) that commercial banks can lend to any industry setting up a new plant; and (ii) a facility to lend cheaply to hospitals that are ramping up capabilities for treatment of coronavirus affected patients.
Banks to see a modest margin squeeze
Alongside the 75bps cut in the policy rate, the SBP has announced to make the interest rate corridor symmetric. This will serve to squeeze banks’ margins, where we estimate a recurring negative EPS impact of c 5% all else the same. According to the SBP, banks’ margins are already high enough to absorb modest compression.
Previously, the reverse repo (Discount Rate) was 50bps above the policy rate and the repo rate was 150bps below the policy rate. Now, both the repo and reverse repo rates will maintain a 100bps gap with the policy rate. This effectively serves to shift the interest rate corridor up by 50bps.
Given that the minimum rate floor on savings deposits (commercial banks only, not Islamic banks) is 50bps below the repo rate, margins will squeeze, all else the same. In the context of the just-announced monetary policy, while the policy rate (which determines lending yields) will reduce by 75bps, the rate floor on savings deposits will effectively reduce by 25bps only to 11.0%. Within our coverage, MCB has a relatively high proportion of savings deposits (more than 50%) while MEBL, being an Islamic bank, does not face any minimum deposit rate.
In addition, the SBP mentioned that it is keeping an eye on asset quality in the backdrop of the coronavirus-led impact on the economy. If there are signs of stress, the central bank has indicated it is ready to step in and take appropriate action. Although details were not shared, this could potentially encompass a temporary relaxation in NPL recognition criteria, in our view.
Banks have underperformed the KSE-100 Index this month. While we acknowledge the risks to revenues (margin squeeze, slower fee income) and asset quality, we believe valuations look attractive even in a stressed case scenario. MCB, UBL and ABL stand out with 10%+ dividend yields, backed by their strong capital buffers.