Pakistan: Underperformance unjustified, but risks remain high

Pakistan’s eurobonds have underperformed since we upgraded to Buy on 22 November, with the EMBI Pakistan index falling by 4% in total return terms versus a 2.6% drop in the EMBI Global through 24 January. This is despite the passage of the Supplementary 2022 Finance Act and SBP Act in the National Assembly earlier this month, the two key prior actions for Executive Board approval of Pakistan's sixth IMF programme review on 28 January (delayed from the initial 12 January date).

While the Finance Act does not need Senate approval to be enacted, the SBP Act does. The bill will be presented to the Senate this week, where the divided opposition holds a slim majority. However, we think there is a broad understanding in Parliament that the IMF programme is necessary, and the bill is likely to be passed this week despite opposition grandstanding. This should pave the way for IMF Board approval on 28 January (staff-level approval was granted in November), which will make way for the next US$1.05bn disbursement.

That said, the performance of Pakistan's eurobonds suggest that markets do not believe Board approval will be forthcoming, either due to failure to implement the prior actions or some other technical barrier, potentially resulting in the collapse of the programme and loss of US$4bn of undisbursed funding. Given significant delays to approval of the sixth review (scheduled for September 2021 after the last rephasing in April), investors could also be worried that the IMF will require a rephasing and/or renegotiation of the programme before approving the review, even if the prior actions are implemented.

We think Pakistan's underperformance is a bit perplexing given the seemingly improved likelihood of programme approval, and retain our Buy recommendation on Pakistan's eurobonds at a mid-price of US$93.38 (mid-YTM of 8.42%) at cob on 24 January on Bloomberg for the PKSTAN 7 ⅜ 04/08/2031s. We think bonds will rally if the IMF review is approved on 28 January, as we anticipate, but acknowledge that bonds could sell off further if approval is not granted. Further, there are a number of other risk factors that could be weighing on bonds, including rising inflation, a persistently wide current account deficit, and bond supply pressure, which we will outline in greater detail in the rest of this note.

Turning to equities, Pakistan equities are cheap and unloved because of accelerating inflation and widening current account deficit. While some softening in food and crude oil prices may be needed for Pakistan to outperform global peers in small emerging and frontier markets, restoring the IMF programme is a necessary, and therefore positive, step.

Monetary policy turns more dovish amid rising inflation

On Monday, the SBP decided to hold rates at 9.75%, in line with previous guidance that it would wait to see the impact of the cumulative 275bps of hikes since September before taking any further decisions (and the expectations of 39 of the 43 economists surveyed by Bloomberg). However, there was also a notably dovish shift in its forward guidance, with the removal of the language in the previous MPC statement that the SBP would move towards "mildly positive real interest rates" on a forward-looking basis.

In its post-MPC investor seminar, the SBP said that it sees the current level of real interest rates as being appropriate on a forward-looking basis. While inflation is expected to remain elevated in the near term due to high global commodity prices and base effects (it rose to 12.3%yoy in December, the second-highest in Asia behind Sri Lanka), it is expected to moderate towards the medium-term target of 5-7% by FY 22/23.

The shift in stance was informed by a slowdown in high-frequency activity indicators in recent months, with growth now projected in the middle of the 4-5% forecast band in FY 21/22 versus the upper end at the last MPC. It was also driven by the recent passage of the Finance Act, which is expected to narrow the FY 21/22 primary deficit to just 0.2% of GDP from the previous 0.7% target. The associated reduction in domestic demand will create space for a more accommodative monetary stance, with Governor Baqir saying the SBP will look through any temporary price increases from the raised taxes.

The SBP expects inflation to moderate over the medium term, with much of the recent increase being driven by food and energy prices (contributing 2.3ppts of the 3.1ppts increase in headline CPI since October), momentum starting to moderate (with month-on-month inflation falling from 3% to 0% in December), and inflation expectations moderating since the last MPC meeting for businesses (but not consumers).

That said, inflationary risks are to the upside, with forecasts for disinflation predicated on moderating global food and fuel prices, relative PKR stability, and a continued moderation in domestic demand. If disinflation does not play out as expected, this could leave the SBP behind the curve after its recent dovish shift. If inflation surprises to the upside, further rate hikes would be required at future MPC meetings (next scheduled in March, April, and June) to prevent a de-anchoring of inflation expectations.

External imbalances remain elevated

The SBP also expressed confidence that balance of payments (BOP) pressures would begin to moderate, with the current account deficit starting to plateau in December after increasing sharply throughout 2021. However, any moderation will take place from alarmingly elevated levels, with the current account balance swinging to a US$9.1bn deficit in the first half of FY 21/22 from a US$1.2bn surplus in the same period of FY 20/21 on a US$13.2bn rise in imports versus US$3.4bn rise in exports.

Annualising the December figure results in a current account deficit above 6% of GDP versus the 2-3% that the SBP deems as being sustainable. That said, the SBP remains confident that it will be able to sustain a deficit of this magnitude in the near term without depleting reserves, with the government expected to receive US$1bn from the upcoming IMF disbursement if/when it materialises, US$1bn from the Sukuk issuance on Monday, US$2bn from the sale of two LNG plants to Qatar-based investors, and remittances remaining elevated at US$2.5bn in December (+11% yoy in H1 21/22 to US$15.8bn).

Further, the SBP sees much of the deficit as being commodity-driven, with food, oil and Covid vaccines contributing c50% of the massive 66% yoy import growth in H1 21/22. Indeed, the non-oil current account deficit actually fell to US$0.7bn in H1 21/22 versus US$2.6bn in FY 17/18, the last year the current account exceeded 6% of GDP, and is projected to end the year in surplus, and machinery imports are also expected to moderate when the TERF stimulus expires at the end of FY 21/22.

That said, a current account of this magnitude is clearly unsustainable. FX reserves have remained under pressure despite high remittances and one-off financing flows (including the US$2.75bn SDR allocation in August and US$3bn from Saudi Arabia in December, without which reserves would be flat relative to mid-2020), and if the IMF review is not approved it could put Pakistan's financing pipeline at risk and cause reserves to drop dangerously low (they are already less than 3 months of trailing goods imports).

And like the SBP's inflation forecasts, import contraction is predicated on lower global commodity prices and a continued moderation in domestic demand, which could cause BOP pressures to remain elevated if it doesn’t materialise. IMF review aside, Pakistan's bonds will likely remain under pressure if there is no clear evidence of a moderation of BOP pressures in the months ahead.

Sukuk issuance causes supply pressure

The last possible explanation for Pakistan's underperformance is concerns over increased bond supply ahead of the government's Sukuk issuance, which priced on Monday at 7.95% for a 7-year, US$1bn issuance (below IPT of 8.25-8.375%). While this will provide some short-term reprieve for the BOP, it may have placed some pressure on Pakistan's existing eurobond curve.

Overall, we think Pakistan's underperformance in recent months is unjustified. With Board approval of the sixth IMF review likely following the passage of the necessary bills in the National Assembly, we think bonds should be trading stronger. That said, this positive view is predicated on the passage of the SBP Act in the Senate this week, as well as a moderation of BOP and inflation pressures that have proven more severe and sustained than we anticipated despite the SBP's monetary tightening.

Conversely, if Board approval is not granted on Friday, or if Board approval is granted but BOP pressures persist in the coming months, we think Pakistan's eurobonds will continue to underperform. We retain our Buy recommendation on Pakistan's eurobonds at a price of US$93.38 (mid-YTM of 8.42%) at cob on 24 January on Bloomberg for the PKSTAN 7 ⅜ 04/08/2031s.

Pakistan equities: Very cheap and unloved

In the last twelve months, Pakistan equities (KSE 100) are down 11%, the worst in Asia ex-Hong Kong, and the FX rate is down 9%, the worst in Asia ex-Thailand.

Rising commodity prices for food (about 40% of consumer spend is on food) and crude oil (net fuel imports at US$85pb oil price amount to about 6.6% of GDP) have driven inflation higher and current account deficit wider (3.1% deficit in 2022, according to IMF forecasts, which were based on flattish average oil prices this year, instead of the 25% increase seen so far).

Rising policy rates (275bps of hikes since mid-2021 to 9.75%) in response have dampened growth prospects, so far without getting ahead of inflation (12.3%). For local investors, the forward equity dividend yield of 8.0% looks attractive compared to a real interest rate of negative 2.5%, but not so much against an 11.3% local currency 5-year government bond yield.

And delays in actions (partly to address a fiscal deficit of 6.2% in 2022, according to IMF forecasts), required to put the IMF programme back on track, have also contributed to a loss of confidence in the currency, which foreign investors care most about. Note that foreigners have been net sellers of Pakistan equities for six of the last seven years.

All of this has left Pakistan as the cheapest equity market in Asia, both in absolute terms (which might be justified by the low representation of higher growth Tech companies in the index and by high inflation) and, more tellingly, relative to the historic average.

Trailing PB is 1.0x (for 19% trailing ROE) is at a 17% discount to the 5-year median.

Forward PE of 4.8x (for 2% consensus earnings growth in 2022 and 8.0% dividend yield) is at a 33% discount to the 5-year median.

In terms of currency valuation, the real effective exchange rate implies the spot FX rate is close to fair value: a return to REER of 100 or to the median 10-year REER would imply appreciation in the spot FX rate of 1% and 5%, respectively.

Pakistan equities are very cheap and unloved. This should make them more sensitive to positive than negative news. Evidence that policymakers are getting on top of controllable factors (eg interest rates and fiscal control) undoubtedly improves the risk-reward trade-off. But, ultimately, it is hard to see Pakistan outperforming small emerging and frontier markets peers until there is a turn in global food and oil commodity prices.

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