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This presentation was prepared for Engro Corporation, to assist with its planning for 2019. 

• Uncertainty about IMF program is being stoked by a misleading distinction between “good” and “bad” IMF programs.  Markets need to be carefully managed, especially after an eventful November 30;
• On this day, interest rates were increased by 150 bps, which exceeded market expectations.  However, after the currency turmoil in the first few hours of November 30, this increase made sense;
• But this does not signal the end of the tightening cycle;
• We hope that Pakistan’s stabilization is not as disruptive as what Egypt experienced in late 2016.  With unhinged market expectations, a free-floating PKR could be too destabilizing;
• Quarterly targets on net international reserves (NIR) and Pakistan’s primary deficit, are likely to be the more binding targets in the next IMF program;
• PKR adjustments and consecutive interest rate hikes should help reduce imports, while soft oil prices and strong remittances should further narrow the current account deficit.  A $13 bln external deficit in FY19 is possible without disruptive policy measures;
• We expect average inflation in the range of 8-9%, and interest rates around 11-12% by June 2019.  Import compression and a subdued informal economy could push down growth to 3-4%;
• Forthcoming policies could dampen the undocumented economy via: the accountability drive; the anti-encroachment efforts; the distinction between filers & non-filers; the effort to expose overseas Pakistani assets and the policy to push for more accurate real estate valuations.  This may bring short-term pain, but should pave the way for medium-to-long term prosperity;
• Despite the geopolitical flux, Pakistan is not as vulnerable as many think. 

• US$ 6 bln pledge by Saudi shores up the PSX, but help from China and the UAE still awaited; 
• Saudi Oil Facility will not reduce CA deficit – just the depletion of FX reserves; 
• Impossible Trinity likely to dominate negotiations with the IMF, which includes the current account deficit; the exchange rate & domestic interest rates; 
• Cannot control all three at the same time – IMF wants PKR to strike the balance.  This will be politically difficult and will complicate the fiscal side; 
• We expect a 100 bps interest rate hike in November 2018; 
• We hope IMF program will focus on unorthodox challenges like: the undocumented economy; undervalued real estate; price-setting driven by supply factors more than demand pressures; and increasing interest rates will not attract foreign capital inflows; 
• Do not think IMF will take a hardline with Pakistan, and will be willing to work with China; 
• China’s offer to discuss assistance and provide guidance should make this reform program different.  We hope this tackles the circular debt, pushes for documentation and accurate valuation of wealth, clamps down on capital flight, tweaks the FTA, formulates an Industrial Policy and strengthens state institutions;
• TLP shakes the government and the Establishment – needs to be handled.  
   

This presentation was prepared for HBL’s client events in Lahore, Islamabad and Karachi in mid-November 2018.  The main points are:

• The strong economic growth since FY10 is not sustainable, as Pakistan’s twin deficits have risen sharply in the past two years.  Financing the deficits is not the solution;
• At doctored papers, we have been watching the external sector since May 2017.  The current focus on financing sources (e.g. Saudi, UAE and China) is understandable, but Pakistan needs to narrow the twin deficits below 10% of GDP.  China’s approach to help is promising;
• PKR/$ and interest rates changes since December 2017 are significant, and driven by external sector concerns – not inflation.  Issue remains how much more demand management the IMF will insist on;
• Debt dynamics (both external and domestic) are frightening.  Policy efforts to narrow the external deficit will stoke the fiscal side via debt servicing, which complicates on-going negotiations;
• Using the circular debt in the power sector, we show how politically difficult structural reforms are.  Despite the heavy political price of implementing real reforms, we argue that GoP has no choice now but to push ahead;
• Monthly current account deficit in Nov and Dec 2018 are critical.  If the external gap is sufficiently narrowed, this will ease pressure on the PKR and interest rates in 2H-FY19;
• With China’s guidance, we expect the next IMF program to tackle stubborn issues like documentation; external sector viability; the need for an Industrial Policy, and strengthening the bureaucracy and state institutions;
• We conclude with three thoughts: (1) whether the PKR/$ is at 137-140 by end-June 2019 or at 145-150+, will have a material impact on the economy; (2) the bilateral relationship with China can be used to set a policy direction that will make Pakistan’s economy more sustainable; and (3) structural reforms will disrupt the economy and require a great deal of political will.  Any government intent on reforms must prepare for this political battle. 

• Finance Minister finally states that Pakistan will seek IMF support;
• FATF visit was poorly managed by regulators/authorities;
• Two months of good news regarding BoP, but FY18 CA deficit increases to $ 19 bln.  With global oil prices up, next 2-3 months are critical;
• Increase in remittances not driven by fundamentals, but accountability;
• External deficit; need to build FX reserves; and insufficient FDI, means heavy external borrowing ahead;
• Heavy GoP reliance on SBP financing in FY19, will have to be reversed.  This will put upward pressure on interest rates, increase debt servicing, and keep fiscal accounts under pressure;
• Do not expect a quantified IMF package till end-Nov;
• GoP must solve the circular debt problem; push documentation and revenue generation; move towards external sector sustainability; create an Industrial Policy; and strengthen state institutions.  This cannot be done in a business-as-usual manner;
• Khashoggi issue could change the Middle East; and undermine Trump’s strategy for the region;
• Oil prices unlikely to spike after sanctions on Iran;
• China will want CPEC to be transparent and succeed.

• Slow start by the PTI government, with some false steps that could have been avoided;
• Recent gas tariff increase is the first right step, which seeks to reduce domestic demand;
• PTI is seeking a middle-of-the-road approach: it has shifted the tax burden on the affluent; provided relief for the poor and concessions for exporters, but has conceded to the demands of tax non-filers (disappointing);
• Sharp reduction in August imports (and current account deficit) is likely one-off, because it has been driven by a fall in the oil import bill.  With the current trajectory of global oil prices, Pakistan’s import bill is likely to increase unless retail fuel prices are increased;
• Portfolio outflows are challenging: lack of policy direction; uncertainty about the IMF; & EM jitters are the main reasons;
• Conflicting policy goals: import duties are being resisted as this would reduce tax revenues. GoP must prioritize external sector over fiscal revenues;
• Unlikely that IMF will reverse Mini-Budget – its focus will be on chronic weaknesses (e.g. circular debt, PSEs, number of filers, fiscal cadaster, etc.).  With twin deficits at 12.4% of GDP in FY18, urgent steps are required;
• US-China trade war gains momentum, but the impact is not widespread enough to swing the mid-term US elections;
• Turkey and Argentina are calm, but the underlying problems have not been resolved;
• US economy is booming but many are talking about an asset bubble.  An increase in US interest rates will hurt EM and slow global growth;
• A global slowdown should not impede Pakistan’s export potential.

• Election results show unexpected stability.  PTI’s inaugural address is uplifting, but not a roadmap;
• Bringing back Musharraf-era people may water down PTI’s clean-up agenda;
• FM (Asad Umar) statement that Pakistan has overcome economic crisis before, does not set the right tone.  Hard steps are required to narrow the external deficit, which PTI appears unwilling to take to avoid an inflationary spike;
• Surprise appreciation of PKR (to 124.5/$) shows that the kerb market is now driving the interbank (SBP) rate – not a good precedent;
• Rising inflation will reinforce expectations for an interest rate hike;
• External deficit in July hits $ 2.2 bln despite PKR devaluations and growth in exports and remittances.  Needs urgent action and out-of-the-box solutions (revisit China-Pakistan FTA and focus CPEC on exports);
• IMF/CPEC politicized by Trump administration, but this should not stop Pakistan from securing an IMF program if GoP approaches the Fund; &
• Turkey’s currency crisis reveals the risk of stubbornly large external deficits.  Loss of appetite for EM risk, means Pakistan’s Eurobond in FY19 will be more challenging.

• PKR adjustment and interest rate hike in July will have macro consequences – there appears to be no game plan.  Market expects further interest rate hike in September;
• Inflation is heading up and could double compared to FY18;
• PKR adjustment has also spilled over to the fiscal side;
• Import compression and lower consumer spending will hit Large Scale Manufacturing (LSM);
• External deficit in FY18 was $ 18 bln.  We estimate that even if external deficit is brought down to $ 12 bln in FY19, and FX reserves are at 2-month cover, Pakistan needs gross inflows of $ 27 bln this fiscal year;
• Skeptical IFIs, iffy US relations, $ payment overhang, and rising inflation mean Pakistan needs out-of-the-box solutions for BoP and fiscal side;
• Expect PTI economic team to give a sobering first address & negotiate an IMF bailout.  Will not be as large as requested, and will not be frontloaded;
• Stabilization program should focus on strengthening key institutions, reforming the power sector and public sector enterprises, developing a “fiscal cadaster” and ensuring provincial support for structural reforms;
• Trump insults Germany, the EU and British PM Theresa May and is determined to dismantle NATO;
• Trump-Putin Summit disaster does not phase the US President.  Anti-Trump anger could help Republicans in the mid-terms and his re-election in 2020.  That will surely change the world.

• Caretaker government takes charge, does not want to talk to the IMF but admits to the dire situation;
• Politics is somewhat subdued given 5 weeks to general elections – IK is not looking good and PML-N witnessing senior level disagreements;
• With sharp PKR adjustment, inflation and interest rates could spike;
• Current Account deficit hits $16 bln, and could maintain this trajectory despite PKR adjustment as market expectations are not being managed;
• SBP FX reserves continue to slide, and we are not convinced the amnesty scheme will help;
• GoP borrowing from banking system same as last year, but strong shift towards SBP financing;
• Next stabilization program will have hard targets for Current Account and FX reserve build-up;
• Terrible timing for the next government – it will have to reformulate the budget, the Amnesty Scheme, CPEC, strengthen key institutions, and clean up the tax collection and power distribution machinery;
• Trump is gearing up for the mid-terms, and could pull off another upset as his divisive policies feed tribal sentiments;
• Kim Jong-un’s diplomatic coup suggests that China is orchestrating;
• Mueller investigation appears to be speeding up;
• Oil price stays below $80/b, and both Russia and Saudi have agreed to increase supply;
• Threat of Pakistan being placed on FATF’s black-list, is exaggerated.

• Nawaz Sharif’s interview on Mumbai’s terror incident in 2008 triggers broad-based backlash.  PTI becomes a serious contender in the next elections;
• Growing dependence on SBP financing (and falling maturity of market debt) is worrying;
• $14 bln CA deficit (10 months) is larger than we projected, and SBP is increasingly concerned about releasing FX as its reserves are being depleted;
• Caretaker government is likely to adjust the PKR, increase interest rates and initiate talks with the IMF in June 2018;
• Our upwards inflation trajectory is playing out, and will continue due to PKR adjustments and likely increase in PoL prices in June and July;
• Interest rate increases will be modest because of Pakistan’s debt overhang (will create fiscal stress in FY19);
• Scuttling of Iran nuclear deal is a point of no return for the Middle East.  Pakistan’s neutrality in Iran-Saudi standoff could be negative for remittances from the GCC;
• Kim Jong-un’s hesitation about meeting President Trump is not erratic behavior;
• Mueller investigation is not going away and may lead to a more divided USA;
• Oil price stays above $70/b with Middle East uncertainty – a good excuse for our policymakers to increase retail prices;
• China-US trade differences will flare up.  This is uncharted territory, and a form of 21st century warfare.

• SBP again surprises by holding interest rates in March, against IMF and ADB advice;
• Banks have stopped lending to the govt and are not using OMOs.  Govt borrowing from SBP has increased very sharply in the past month, which will not be appreciated by the IMF;
• An interest rate increase and PKR devaluation is expected by the caretaker government in June;
• We have increased our projected current account deficit to $ 15.4 bln in FY18, due to government inaction to reduce the dollar drain.  But exports could exceed $ 25 bln after many years, even if SBP’s FX reserves at end-FY18 dip below $ 10 bln;
• With inadequate plans to narrow the external deficit, budgeting for FY19 is baseless.  Federal Budget FY19 lacks credibility;
• The Amnesty Scheme is an attractive carrot but its fate is uncertain.  Enforcement (stick) is unlikely under a caretaker set-up.  Must wait for the next elected government;
• Trump tariffs could unleash a trade war against China;
• A new world order may emerge with bilateral trade negotiations trumping “rule based” laws;
• North Korean leader appears to have gotten the upper-hand over US, China, Japan and South Korea.