Pakistan: An Attractive Frontier Market Pick in Asia

Macroeconomic Outlook

After years of full of challenges, Pakistani economy is now out of the woods with high-single digit GDP growth rates projected for the upcoming two years. Even if the country still faces some significant political risks and has some vulnerabilities due to high indebtedness, we believe the provided risk-reward profile is very compelling at this point.

Pakistan is one of the few frontier markets that are expected to receive a credit rating upgrade this year. As of now the country is rated as B-by Standard & Poor’s with positive outlook with opportunities and risks recognized.

Pakistan GDP Growth and Sectoral Composition

This year is crucially important for Pakistani economy as about 40% of the country’s outstanding debt, which amounts to $45 billion, is due to mature in 2016, of that $41 billion is in local currency. However, we believe that existing IMF funding and the Chinese investment in an economic corridor will offset the pressure as we see no reason to panic for the outlook of the economy.

The government embarked on a number of reforms, many under the aegis of an Extended Fund Facility (EFF) arrangement with the IMF, which included strengthening the State Bank of Pakistan (SBP, the central bank) autonomy through an establishment of an independent monetary policy council for rate setting. Following that, an interest rate corridor was introduced with a ceiling rate of 6.5% and the floor rate of 4.5%. Given the core inflation prints in 3-3.5% range and Pakistani Rupee trading in the narrow range of 104-105 for the past year, the improved monetary transmission mechanism has been successful to stabilize the economic indicators, which will lead a less hazy economic outlook and lower fundamentals risks.

Secondly, The China Pakistan Economic Corridor (CPEC) is a $46 billion FDI pledge from China which will serve as a catalyst for increased economic growth as well as risen geopolitical interest from other countries. Some other counties including Russia, the UAE already announced billion dollar mega projects. Eventually, we will be able to see infrastructure developments needed to boost the economic growth in the long-term which the country has lacked for years.

At the end of 2015 total public debt to GDP ratio stood at 61.5%, showing an improvement of 20 basis points y/y. Meanwhile, total external debt and liabilities rose to 7,2 trillion rupees which amounted to 23.4% of GDP. Having improved its risk profile, Pakistan could have managed to lower its borrowing costs from global financial markets. Moreover, in domestic credit markets, we saw the average rate for outstanding loans in Pakistani banking system coming down to 8.58% in February 2016 from 10.59% in the same month of 2015, while outstanding rates for deposits lowered to 5.03% from 6.7% within the same timeframe. Thanks to the stabilized inflation rates and the new monetary policy framework, we foresee the continuation of the benign trend in the credit markets.

Equities

Pakistan - Karachi Stock Market Performance versus Emerging Asia ETF

Founded on September 18, 1947 in Karachi, the largest city of Pakistan, Karachi Stock Exchange has more than 650 companies listed with total market capitalization of $72 billion. It ranked third in 2014 amongst the top ten best performing markets in the world according to analysis by Bloomberg. Our views on specific sectors are as given by.

As discussed above, the ongoing trends in credit markets are in favor or banks. Not surprisingly, total assets grew by 17% system-wide last year, reaching a record level of 14,143 billion rupees (investments and advances grew by 30% and 8%, respectively). In such a growth period, NPLs only totaled 11.4% of total loans (12.3% in 2014). Moreover, Pakistani banks built provision that covered 85% of total NPLs, lowering net NPL ratio to 1.9%. Despite the fact that credit metrics were still not good, banks showed a major development in terms of quality. Commercial banks averagely recorded a ROE of 25.8% when tax excluded up from 24.3% in 2014, as they posted a Tier-1 ratio of 13.1% for full-year 2015, up from 12.9% in 2014. Thanks to increasing profitability and strong capital structures, we are of the opinion that Pakistani banking stocks provide a good environment for not faint-hearted investors looking for opportunities in frontier Asia. The following is our picks from Pakistani stocks.

Pakistan - Stock Selection

We believe that Pakistani banking stocks offer attractive value, thus we pick four of the banking stocks with the greatest market cap. Additively, we add an industrial to the list, Lucky Cement, which, we believe, solidifies our portfolio with an outlook for increased spending on construction materials due to the infrastructure deficit and its rarely seen profitability metrics.

Turkish Central Bank Lost It?

Since 2006 Turkish central bank has officially been in pursuance of price stability after reforms such as law amendments regarding the formation of the bank differ the way the bank function. Until 2009, the bank irrefutably had been on the path to achieve price stability. However, in the following years, we have seen the bank using non-conservative tools to reach the desired results that have unsurely included the price stability.

Over the past five years, Turkish central bank has failed to lower the inflation rate to 5%, which it set a long-term target for the price stability, while the rest of the world has struggled to slay deflation. According the December 2015 inflation report, consumer price index in Turkey increased by 8.81% y/y. Food prices have been heavily accused for the higher than expected increase which were up 13.7% (nonprocessed foods). This was highly elusive given the country’s food self-sufficiency. But, more importantly, I-index which excludes food, drink, and energy prices (or core inflation as some say) rose by 9.5%, which clearly reveals the central bank’s painful failure.

Tightening was simply what was expected from the central bank in such cases. Turkish central bank referred to the U.S. Federal Reserve’s policy normalization as the trigger to simplify its own monetary policy. However, after the Fed move in December, Turkish central bank kind of postponed its own normalization process, referring this time to high volatility in the financial markets as a prerequisite. As this was one of the worst cases ever happened in the history of communication in central banking, its credibility got shredded again, worsened already dismal expectations. Now, according to the participants of the survey of expectations, a Turkish central bank reaching its inflation target is unlikely to occur in two years.

It is a fact that Turkish central bank has become less and less resistant to political pressures, as concerns about the bank’s independence have remarkably risen. If so, one should argue that the central bank has also lost its influence on the rates in the credit markets. In other words, politicians’ repeated calls for lower rates to boost growth has resulted in or are to result in with a monetary policy that lacks ability to impact interest rates. See the chart below.

At this point the famous issue of output-inflation trade-off springs to mind, and what is so interesting about the Turkish case is that the central bank has presumably managed to fail in both sides. This all has been a central-bank failure of epic proportions.