The State Bank of Pakistan (SBP) held its policy rate at 15% yesterday, in line with the expectations of 29 of the 36 analysts surveyed by Bloomberg (the rest projected 50-150bps of hikes). This comes on the back of a cumulative 800bps of hikes since last September, including above-consensus rate hikes at the last two MPC meetings, which the SBP said in its MPC statement “are expected to work their way through the system over the coming months.”
The decision to hold came despite a sharp rise in inflation to 24.9% yoy in July, pushing the real policy rate to -9.9% (versus a -3% median across our sample of 66 emerging and frontier markets). However, the increase was driven by the removal of fuel subsidies (which pushed energy inflation to 66.6% yoy in July) as well as rising food prices (which reached 28.3% yoy), and was in line with the SBP’s expectations. Indeed, the SBP’s inflation and growth forecasts for FY23 were unchanged from the July MPC at 18-20% and 3-4%, respectively.
Alongside signs of moderating domestic demand and improvements to Pakistan’s external position, the MPC adopted a wait-and-see approach at this month’s meeting. The decision to hold was supported by projections that inflation will peak this quarter and decline sharply to 5-7% by the end of FY24, with projections for moderating growth and external imbalances driven in large part by the budgeted 3% of GDP of primary deficit consolidation this fiscal year. That said, there is upside risk to the SBP's inflation forecast given the recent heavy monsoon rains in southern Pakistan, which could reduce crop production.
In addition to moderating demand, the SBP has taken “temporary administrative measures” to curtail imports, including requiring prior approval for the import of machinery and vehicle and mobile phone components, which the SBP acknowledged “are not sustainable and will need to be eased in coming months” and replaced with other measures to reduce energy imports (centred on demand reduction measures like encouraging remote work and carpooling).
Indeed, after the trade deficit widened from US$3bn in February to an alarming US$5bn in June on the back of a US$2.4bn rise in energy imports, the deficit fell to an 18-month low of US$2.7bn in July on the back of a US$2.3bn drop in energy imports and US$600mn drop in non-energy imports (totalling -37% mom and -10% yoy for imports, offset in part by a 23% mom and 4% yoy decline in exports as global demand moderated).
Alongside improved IMF prospects, the PKR has appreciated by c10% since the end of July. However, this has not yet translated into increased reserves, with the SBP’s liquid FX reserves dropping to just US$7.9bn on 12 August (just 1 month of trailing goods & services imports and <25% of Pakistan’s gross external financing requirement of US$33bn in FY23). The SBP attributed this decline to “the drying up of official inflows” from multilateral and bilateral creditors and a lack of commercial market access.
Board approval of Pakistan’s IMF programme, on which a staff-level agreement was reached last month, is necessary to unlock funding and support Pakistan’s goal of boosting reserves to US$16bn by the end of FY23. The review is due to be presented to the Board next Monday (29 August), and with the IMF’s Resident Representative saying earlier this month that Pakistan had completed all necessary prior actions, approval is likely barring any last-minute policy missteps.
In addition to the prior policy actions, the SBP says that the IMF also required further financing assurances to approve the programme. With Pakistan securing US$4bn of support from “friendly countries” (including US$2bn from Qatar, US$1bn of deferred oil financing from Saudi Arabia, and US$1bn of investments from the UAE), the SBP says that its external funding pipeline for FY23 has reached US$37bn versus external financing needs of US$33bn, which will boost Pakistan’s faltering reserves.
If the IMF programme is approved on 29 August, unlocking an immediate disbursement of nearly US$1.2bn and extending the programme through June 2023 with an additional US$950mn of financing, Pakistan’s balance of payments will be granted a temporary reprieve. However, with political uncertainty continuing to grow and elections looming by October 2023 at the latest, the government will be hard-pressed to keep the programme on track.
Pakistan’s ability to plug its external funding gap is predicated on its ability to contain the current account deficit below 3% of GDP (down from 4.8% of GDP in FY22) and primary deficit consolidation of 3% of GDP in FY23. Any slippage from either of these targets will require further rate hikes from the SBP, renewed rupee depreciation, and/or fresh external financing to plug the gap and set reserves on an upward path from the current unsustainably low levels.
From both the price and external accounts perspective, the SBP's pause may not signal the end of the current hiking cycle. If inflation fails to moderate in line with the SBP's forecasts, due either to upside surprises to food/energy prices (which the SBP may decide to look through) or fiscal slippage that prevents the moderation of domestic demand (which the SBP will likely respond more forcefully to) then further hikes may be needed.
Likewise, if the current account deficit fails to contract in line with the SBP's projections, then further hikes will likely be needed to prevent a BOP crisis and offset the inflationary pass-through from rupee depreciation. But for now, the SBP says that it will remain data-dependent and has opted not to provide any concrete forward guidance due to elevated domestic and global uncertainties. While we think this is a reasonable approach, the SBP should stand ready to react forcefully if needed to tame external and price pressures. The next MPC meeting is on 10 October.
Fixed income implications
We made the PKSTAN 7 ⅜ 04/08/2031s one of our top picks for H2 22 last month on the basis of rock-bottom bond prices, which had reached US$47.5 (20.6% YTM) versus our base and bear case recovery values of US$59 and US$53, respectively, at a 12% exit yield. On the back of positive IMF headlines, the ’31s rebounded sharply to US$64.5 (14.5% YTM) last week and have since moderated to US$59.1 (16.4% YTM) amid a broader risk-off backdrop, in line with our base case recovery value.
After rallying by nearly 25%, the upside on the ‘31s has greatly diminished. However, approval of Pakistan’s IMF review next week (which in our view is highly likely) could provide a meaningful boost to bonds. How large and how long it lasts, however, will depend on how Pakistan’s fiscal and external accounts evolve in the coming months and whether the current administration is able to stay the course on its difficult IMF-backed reform agenda despite mounting political risks.
Markets will likely continue to price the risk of programme slippage into Pakistan’s bonds, which will cap the upside. That said, we think if Board approval is granted, followed by several months of data that affirms the SBP’s projections for moderating external pressures and points to ongoing adherence to Pakistan’s fiscal targets, the z-spread on the ‘31s could compress to 1000bps (all else equal in terms of global risk sentiment). This implies 12pts of upside relative to current pricing.
As such, we retain our Buy recommendation on the PKSTAN 7 ⅜ 04/08/2031s at US$59.1 (16.4% YTM) at cob on 22 August on Bloomberg, with any IMF-induced or broader risk-on rally above the cUS$70 threshold potentially providing an opportunity to take profits or reduce exposure given looming political risks and the consequent risks to the IMF programme after this round of reviews and a weak outlook for longer-term structural reforms.
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