Free Presentations

• Inconclusive IMF discussions deflate market sentiments, but the EFF is not under threat.  Contentious issues are the revenue shortfall and the persisting growth of the circular debt;
• The IMF wanted a mini-budget to generate additional taxes and to increase utility rates to curb the circular debt.  However, GoP argued that with food inflation at near record highs, such steps could destabilize the PTI government;
• In the past month, expectations of a growth phase have swiftly ended.  With the government struggling to manage food costs, it is on the defensive and the IMF mission has added to the sense of gravity;
• Steps to bring down food prices and the fact that YoY food inflation touched 20% last month, suggests a sharp fall in food inflation in the coming months.  This will pull down headline inflation, and add further pressure on SBP to cut the policy rate;
• While we acknowledge that the inflation angle could justify SBP holding rates at current levels, we think the political pressure could tip SBP’s hand in March 2020;
• Carry trades continue to grow and have reached $ 3.2 bln as of Feb 19th.  Media and the Senate have taken a strong interest in these dollar inflows (mostly negative), which means SBP will remain under pressure to ensure that these funds are carefully monitored, especially in terms of how the authorities use the carry trades;
• In our view, FBR revenues could get a boost if imports increase in the remaining part of FY20.  With FX reserves above the IMF’s end-June 2020 target, it may be tempting for SBP/MoF to allow for an increase in imports.  However, this is an unwise use of hot money;
• The IMF Staff Paper is expected in the next 2 or 3 weeks, and will be critical to better understand Pakistan’s economic outlook.  In our view, the IMF should revise its BoP projections for FY20 and increase SBP’s FX reserve target to cover at least 3 months of imports.  This means the net international reserve (NIR) target for end-March and end-June will increase;
• Our book review of McCartney and Zaidi’s 2019 book on Pakistan’s political economy, argues that a fresh assessment is necessary if one wants to understand why Pakistan has failed to reform its economy in the past three decades.  We think the narrative on Pakistan’s economy must change to achieve real economic reforms. 

• The IMF Staff Report released in December 2019, conveys a more somber outlook than what the market expected.  While the IMF is impressed (and surprised) by the narrowing current account deficit, it raises concerns about the fiscal side;
• Although Pakistan fell short of the Q1-FY20 revenue target (albeit an indicative target) by Rs 107 bln, the impressive performance was driven by non-tax revenues.  The report also highlights how the bulk of taxes collected in Pakistan happens at the import stage;
• This reveals the lack of documentation of Pakistan’s economy.  While all custom revenues are collected at the import stage, the report shows that 15% of direct taxes and 58% of sales tax were also collected at the ports in Q1-FY20;
• With the EFF projecting FBR to collect over Rs 3 trn in 2H-FY20, we question whether GoP has a plan to generate this amount, or whether a revenue focused mini-budget is likely;
• In reading the Staff Report, structural reforms appear to have been side-lined as the authorities are compelled to tackle the hemorrhaging by increasing utility rates, instead of fixing the underlying problem;
• Despite the sharp narrowing of the external deficit (from $ 8.6 bln in 1H-FY19 to only $ 2.2 bln this year), we question why the IMF has not changed its BoP projection for the full fiscal year.  From the IMF report, SBP’s FX reserves are projected at $ 11.2 bln by end-June 2020, which has already been exceeded by end-December 2019.  This means the external sector targets for FY20 are not binding;
• We observe that carry trades have exceeded $ 2.4 bln so far in FY20, which explains why the rupee has been appreciating in FY20.  Having said this, the Staff Report claims the rupee has “stabilized” at 155/$, which means further appreciation is not likely.  The report warns that if program objectives are not met, this could threaten this quantum of external financing;
• We are disappointed that documentation is not given much importance in the report, and the likely imposition of a fixed-tax regime on traders, is a climb down.  We argue that the authorities have shied away from taking difficult decisions, which means the underlying dysfunctions will remain;
• We also flag that growing unemployment and job insecurity is beginning to hurt the PTI government, and if economic growth is not prioritized, pressure on the government will continue to increase;
• Finally, we question why CPEC is not center-stage.  We suggest that from a geopolitical perspective, the on-going EFF will not allow CPEC to anchor Pakistan’s economy. 

• Appreciating Rupee and growing FX reserves, support the claim that Pakistan’s economy has stabilized; 
• The sharp contraction of the current account coupled with rising carry trades, has pushed SBP’s reserves past $ 10 bln.  SBP is now buying dollars from the interbank market to manage the Rupee parity;
• The stock market rally in the past month, shows a significant improvement in market sentiments;
• Fiscal revenues collected in 1Q is impressive despite the recessionary conditions.  Driven primarily by GST, direct taxes still lag behind as traders refuse to document their operations – February deadline still looms;
• Carry trades continue to grow but the pace has eased in recent weeks.  Currency comfort will ensure that 3-month T-bills (held by foreign fund managers) are rolled-over.  However, we are concerned the IMF may not approve of the appreciating Rupee;
• Interest rate cuts also being delayed for fund managers to roll-over dollar placements;
• M2 growth is subdued because of slow private sector credit off-take.  Currency in circulation hits 42.9% of total bank deposits, a clear reflection of the resistance to documentation and using banks;
• Sharp fall in current account deficit in first five months of FY20, is driven by imports (more specifically because of the economic slowdown and soft oil prices).  Exports post a modest increase;
• Foreign portfolio inflows in November help SBP build its FX reserves, and will make NIR targets easier to meet;
• YoY inflation is likely to fall in the remaining part of FY20.  Gas price increase and high food inflation are one-offs;
• With the sharp containment of the external deficit, our Rupee-Dollar projections have changed significantly for FY20 – we see the parity at 160/$ by June 2020;
• As GoP gears up for post-stabilization growth, it should adopt pro-market policies instead of the easier pro-business policies that suit the status quo;
• CJP’s decision to invalidate the extension of COAS term, and the incendiary language used in General Musharraf’s death sentence, reveals an unprecedented showdown between two key institutions in the country.  Executive appears aligned with the Pakistan Army;
• Prime Minister’s last-minute withdrawal from Malaysian summit of Islamic leaders, allegedly because of Saudi pressure, shows how Pakistan’s economic weakness is compromising the country’s policy independence.  This may incentivize the executive to take hard steps to address Pakistan’s economic vulnerability. 

• IMF review mission is pleased with progress on the EFF, and Pakistan posts a CA surplus in October after many years of deficits;
• Market sentiments have improved, not just in the PSX but also amongst businessmen & corporates;
• There has been an exponential increase in foreign investment in T-bills (hot money).  Of the $ 1.08 bln realized in T-bills so far in FY20, $ 630.8 mln has come during the period November 1-19.  With no change in domestic interest rates, we expect this momentum to continue;
• This is a source of much comfort for SBP: (1) it keeps the PKR stable and builds SBP’s NIR; (2) it provides deficit financing, which means less crowding out; (3) it generates Rupee liquidity, which could allow SBP to ease its OMOs; and (4) it does not increase Pakistan’s external debt;
• But hot money is a double-edged sword: this money can leave Pakistan as quickly as it is coming in.  This adds a new player in the FX market, and questions are being asked whether SBP is prioritizing this player over domestic constituents;
• Could this keep the PKR stable till end-December?  And if so, could this trigger an import-led growth phase?  Issue is: can Pakistan afford a growth phase so early in the EFF? 
• So far, the improvement in the external sector is driven entirely by a fall in imports (soft oil prices have clearly helped).  Export growth has been anemic, while textiles are stagnant.  Non-oil imports have increase in October, after trending down for most of 2019.  If this continues, then we know that the import recovery is real (and could become problematic);
• With the stable Rupee and stagnant retail fuel prices, inflation has peaked. We revise down our average inflation projection to 10½ – 11½% for the year.  We also reduce our PKR projection to end the year at 162-163/$
• Asad Umar is brought back into the cabinet as Development Minister, and strongly defends CPEC against US criticism that OBOR is part of China’s debt diplomacy;
• Could this be a signal that Pakistan will prioritize real reforms and ramp up CPEC 2.0? 

• Pakistan gets an extension from FATF till February 2020.  While the language in the FATF report is stern, we expect a drawn out process but no surprises;
• Expectations of a softening monetary policy are misplaced – a token 25-50 bps cut is possible.  This is because Pakistan’s BoP cannot afford a growth phase that will increase imports;
• The current account deficit (CAD) in 1Q-FY20 BoP shows a significant contraction (a gap of $ 1.5 bln compared to a deficit of $ 4.3 bln last year), because of a sharp fall in imports.  This can be traced to the economic slowdown; the depreciated Rupee and soft oil prices;
• If these conditions reverse and the CAD begins to rise – and this undermines SBP’s ability to build its FX reserves – the Rupee could come under pressure in 2H-FY20;
• FX reserves only increased by $ 470 mln in 1Q-FY20, but is targeted to rise by $ 2.2 and $ 3.5 bln in 2Q and 3Q, respectively.  It is important to realize that Pakistan has just started the IMF program, and it is too early to declare victory on the economic side;
• SBP data shows that foreign investment in T-bills/PIBs (what we call hot money), brought in about $ 366 mln so far in FY20.  This will not be enough to meet the IMF’s net international reserve (NIR) targets;
• Inflationary pressures may have peaked at 12.5% YoY in September 2019.  This is because of the economic slowdown; the appreciating Rupee; and stable fuel prices.  While this may allow YoY inflation to fall in the months ahead, average inflation will continue to rise for the next 5-6 months.  This will confuse the market unless SBP manages expectations more proactively;
• The fiscal side still remains challenging.  With an unchanged FBR revenue target for the year (which is ambitious), slippages will create borrowing pressure on banks and make the crowding-out of the private sector more acute.  The fiscal side will not support a meaningful cut in interest rates;
• Going forward, our outlook is as follows:
•             Revival of growth is difficult in FY20 (2½-3% growth this year is realistic);
•             Stabilization measures could become tougher in the remaining part of FY20;
•             The Kashmir annexation could flare up and dominate proceedings; and
•             Pakistan and China must come to a clear understanding on the timing and scope of the second phase of CPEC.  This is the best path to economic growth in FY21, with a focus on creating manufacturing jobs, import substitution and labor up-gradation.  CPEC needs to be more transparent. 

• The IMF review mission was earlier than scheduled to discuss the shock 8.9% (of GDP) fiscal deficit in FY19.  Market expected fiscal targets in the EFF to be changed (relaxed somewhat), but this didn’t happen;
• First 2 months of FY20 have been good for Pakistan’s BoP.  Import compression is not just because of softer oil prices, but reveals an across-the-board economic slowdown;
• Pakistan needs to maintain this narrowing for the remaining past of FY20 to stay on track with the EFF’s projections;
• SBP’s FX reserves have only increased by $ 1.3 bln since the start of the EFF.  Analysts must realize that SBP’s net international reserves (NIR) must increase by $ 2.2 and $ 3.5 bln in Q2 and Q3-FY20, respectively.  This is likely to put pressure on the Rupee;
• SBP’s decision to hold interest rates has calmed the market.  With the shift of government borrowing away from SBP financing, and likely fiscal pressures in 1H-FY20, an interest rates cut is unlikely till Q3 or Q4-FY20;

The following external developments are significant:

1. India’s annexation of Kashmir (August 5) has not generated global outrage.  If this issue is ignored, it increases the likelihood of an armed conflict across the Line of Control;
2. The attack on Aramco’s largest oil processing facility (September 14) was very effective.  The US-Saudis have blamed Iran, and the EU has followed this lead.  Iran still denies responsibility and has challenged countries to prove their allegations.  Aramco was incredibly quick to overcome the impact of the strike, and global oil markets have remained calm.  However, Iran is likely to stay on the offensive unless US sanctions are eased; &
3. President Trump and the Saudi crown prince (MBS) have asked Imran Khan to intermediate between the Saudis and Iran.  This is a significant opportunity for Imran Khan (whose global stature is growing), not just to ease tension in the Middle East, but also to ensure global intervention in Kashmir, and nudge President Trump to restart US-Taliban talks;

As opposed to a sobering economic outlook, Pakistan’s geopolitical standing is a source of strength. 

• MoF inverts the yield curve in record PIB auction on 21 August;
• Market interprets inversion as a signal that interest rates will be reduced by 100 bps in 2020.  LT yields soften further as banks scramble to buy longer-term PIBs in the secondary market;
• This change in market sentiments is driven by the “re-profiling” of SBP’s holdings of 6-m T-bills.  Over Rs 7 trn is converted, primarily into 10-year PIBs;
• We are skeptical that this change in sentiments will remain, as BoP pressures in Q2-FY20 could weaken the PKR, which would stoke inflation and increase interest rates;
• Banning GoP borrowing from SBP is a positive step and should force GoP to better manage its public finances.  We are also hopeful this will improve the operations of the Debt Management Cell, and compel GoP to accept SBP advice on how to interact in the primary market;
• July’s Balance of Payments is good news, but does not necessarily mean the external problem has been solved.  Imports are down because of low oil prices, and exports show across-the-board increases.  Pakistan needs an average monthly current account deficit of $ 560 million (or less) to stay on track with the full year EFF target;
• LSM contracts by 3.6% in FY19 compared to an increase of 6.4% in FY18.  This is a clear indication that Pakistan’s economy was in recession last year, and is likely to remain in a recession this year.  Processed foods, autos, iron/steel & consumer durables post sharp downturn as purchasing power is squeezed;
• Softer oil prices have reduced our inflation projections for FY20, more so if GoP decides to reduce retail fuel prices in September.  This could be reversed if BoP pressures build later this year;
• Pakistan’s debt dynamics are increasingly alarming.  The stock and debt servicing of dollar debt has been increasing exponentially in the last two years, while domestic debt servicing shows a similar increase last year.  In FY19 alone, Pakistan’s total debt increased by 35%, which means Pakistan is in a debt trap;
• Risks ahead: (1) tax collection to achieve the ambitious revenue target for FY20; (2) reversal of interest rate outlook, which will hurt PSX; and (3) the proposed $-denominated NSS instrument.  The latter is a reversal of capital market reforms of 2000, and could hit term deposits at commercial banks;
• We remain concerned about FATF, but acknowledge that the recent blacklist scare is politically motivated.  Since the on-going IMF program is contingent on avoiding the blacklist, we are confident that Pakistan will avert global isolation;
• We end by saying that stabilization alone will not solve Pakistan’s stubborn economic problems.  Hard steps are needed, but have not been forthcoming. 

• The Extended Fund Facility (EFF) focuses on known structural weaknesses, but is different from previous programs in three ways: (1) it relies heavily on funding from friendly countries; (2) it highlights the resistance to reforms that undermined previous programs; and (3) it talks about the complications created by a vibrant informal economy;
• Despite a long list of targets that are to be met, the program is surprisingly light on details to jumpstart tax revenues.  The IMF report has nothing to say about the fiscal cadaster, which is disappointing;
• The successful meeting between Imran Khan and President Trump, creates a one year window during which the US will be positively inclined to help Pakistan;
• Unlike previous programs, this EFF will only allow for a modest increase in SBP’s FX reserves;
• Using back calculations, we project the average PKR/$ parity in FY20 to be 171.3/$, which means most of the currency adjustment required in the EFF have already happened;
• The projected BoP has some interesting insights: (1) the services balance falls throughout the period FY20-FY24; (2) the primary income balance continues to increase; (3) DFI becomes the main source of financing future current account deficits; and (4) from FY21 on, Pakistan will have to rely increasingly on $s from private sources (not official creditors);
• Despite the sharp currency adjustments last year, Pakistan’s trade flows have not changed much.  This is problematic, as Pakistan has agreed not to impose any regulations to discourage imports during the EFF;
• This means only the Rupee can be used to narrow the trade deficit;
• The growing focus on non-debt inflows is required to exit the $ debt trap, but we still think the projections on financing the external deficit are wishful;
• YoY inflation is projected to increase throughout Jul-Dec 2019, but will fall afterwards.  We project average inflation above 13% this year, which is higher than SBP’s 11-12%;
• The revenue targets in the EFF are ambitions, with few details about how they will be achieved.  This allows for generous expenditures;
• The fiscal deficit this year will be larger than last year, both in nominal terms and as a percentage of GDP;
• The main risks in the EFF are: (1) relying only on Rupee adjustments to meet ambitious FX reserve targets; (2) whether SBP will be able to control inflation that is generated by the weaker currency; (3) there are very few details about how the authorities can generate higher taxes during an economic slowdown; and (4) the monetary policy tightening cycle will crowd out the private sector and could destabilize the banking system. 

• Federal budget hits the right note by being realistic (lower growth and rising inflation in FY20) and focusing on revenue measures.  There is a good balance between direct taxes (the increase in income tax slabs) and indirect taxes (GST on most household items), even though these measures will hurt;
• However, in a recessionary environment, the 33.7% increase in the revenue target is too ambitious, unless collection of direct/indirect taxes gears up like never before;
• The biggest disappointment is the lack of any effort to consolidate Pakistan’s total debt.  By admitting that Pakistan’s fiscal deficit could be as high as Rs 3.6 trln in FY20 (without provincial cash balances), this implies that GoP will continue borrowing at a rapid rate;
• New SBP Governor gives a professional/competent press conference.  He states that Pakistan will maintain a “managed currency” regime and that interest rates will be used to combat inflation.  We have misgivings about both issues, as we feel these will not be effective in stabilizing the economy;
• Chasing inflation (i.e. hiking interest rates to contain future inflation) will exacerbate the debt problem, and could weaken the banking system.  While the GoP projects inflation at 13%, our projection of average inflation in FY20 is higher at 14.7%;  
• FATF continues to be an understated risk.  The amended AML legislation is being resisted by parliament, while FATF has complained that Pakistan hasn’t done enough to counter terrorist financing.  The latter entails targeting specific groups and strictly monitoring cash couriers;
• While the projected current account deficit ($ 7 bln) is almost half the gap this year, we feel this is too large.  One must realize that the external deficits in FY17-FY19 were too large, which is why the country is now in a debt trap.  The external financing expected in FY20 (Rs 1.8 trln) is also too ambitious;
• The projected 78% increase in total debt servicing in FY20 (over this year) is a clear indication that the debt trap also characterizes Pakistan’s domestic debt;
• IMF program details will give a better handle on: (1) how will the PKR/$ parity fare; (2) how much further will interest rates increase; and (3) what is the target for SBP’s FX reserve build up;
• 1H-FY20 will be very challenging, as Pakistan’s economic vulnerability is unprecedented. 

• The past month has seen important changes in Pakistan’s economy:
• 1.      New SBP Governor is experienced with IMF programs, but can he handle the public/political backlash? 
• 2.      IMF agreement has been signed and will be put to the IMF’s board for approval.  It’s underfunded, which means debts repayments have been rescheduled (especially to friendly countries);
• 3.      Prior actions have been taken on the PKR/$ parity and interest rates; these could complicate Pakistan’s already worrying debt dynamics;
• 4.      The Asset Declaration Ordinance 2019 is a much sweeter that what Asad Umar was going to propose, and even easier than the PML-N version;
• 5.      Opposition parties are gearing up to use these developments to undermine the PTI government; &
• 6.      The current account deficit for April is $ 1.24 bln, which is higher than expected. 
• The currency & interest rate adjustments have not narrowed the trade deficit much, and little attention has been paid to Pakistan’s stagnant exports;
• The slowdown in LSM (July-March 2019) is driven by food, autos, metals, electronics and cement.  This shows a sharp slowdown in aggregate demand and consumer spending;
• Fiscal gap of 5% in 9 months implies the full year gap could be above 7% of GDP.  A large part of this is being funded by SBP, which will have to be reversed in the stabilization program;
• While the CA deficit (Jul-Apr) is $ 4.3 bln lower than in FY18, further narrowing is required.  We project the external gap to be $ 12.8 bln this fiscal year, which may have to be slashed to $ 4 bln in FY20.  The trade deficit has only narrowed by $ 1.9 bln, which is disappointing;
• If further devaluation of the Rupee and higher retail fuel prices are required to narrow the external deficit, this could boost inflation to 17-18% in FY20.  The current economic challenge is perhaps unprecedented;
• Given the CA contraction that is required, policies alone may be insufficient.  Pakistan needs an anti-import campaign, to move towards import substitution and to change CPEC to become more export-oriented;
• Interest rate increases should be capped as this could dig the country deeper into the debt trap;
• We are concerned about the sidelining of Y. Dagha (Finance Secretary) and FATF’s assessment of the generous amnesty scheme;
• We expect tough policy measures before the forthcoming budget, and are concerned that the finance team may have over-committed in the next IMF program.  A stalled program would put Pakistan on a perilous path.