Presentations

• 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.

• Asad Umar’s resignation is poorly timed and could delay the IMF program;
• In our view, his ouster was engineered from within PTI, which reveals a possible shift in policymaking away from PTI’s ideology.  We think the amnesty scheme may have been the pretext to remove the FM;
• IMF mission to visit Pakistan in end-April, which should finalize the next program;
• FX reserves have increased because of the $ 3.2 bln borrowed in March 2019;
• World Bank’s projections show a somber outlook for FY19 and FY20, with low growth and high inflation;
• IMF projections, on the other hand, are absurd: they reflect no stabilization program for the next five years, and yet also show that Pakistan is able to finance growing twin deficits without losing macro stability;
• Autos and construction continue to slow industrial growth;
• Single Treasury Account will be resisted by weak banks, but is required to sharply reduce GoP borrowing from the central bank;
• Banks are rightly concerned about the repercussions of a further interest rate shock;
• Pakistan’s BoP narrows compared to FY18, but the real reason is that import numbers for FY18 have been revised upwards.  Now the current account deficit in FY18 is $ 19.9 bln compared to $ 19.0 bln;
• No perceptible change in Pakistan’s trade flows this year, which means policy efforts to narrow the trade deficit have not yet worked;
• We think the current account deficit this year could be contained at $ 11-12 bln (compared to $ 20 bln in FY18), but this will have to be brought down further to $ 7 bln in FY20.  The required import compression will keep growth around 3% for the next two years;
• The amnesty scheme that was to be announced by Asad Umar has been rejected as “too complicated” by the new Finance Adviser.  We think this means it was too harsh/punitive to tax evaders.  We also sense the IMF will have serious objections to the moral hazard problem this creates for tax-abiding citizens;
• We see Asad Umar’s departure as symptomatic of the vested interests regaining the upper hand in policymaking.  This does not bode well for the forthcoming IMF program. 

Updated: 25 March 2019.  

• IMF mission head to visit on March 26.  Change in GoP’s narrative reveals that programs details will be discussed & could be finalized.  As we have discussed earlier, this should change how the PKR is managed;
• World Bank document Pakistan@100 discusses how Pakistan could become a $ 2 trillion economy by 2047;
• But this requires a change in the policy making process, which WB thinks has been “captured” by self-serving elite interests.  This is uncharacteristically blunt for an IFI;
• Report identifies and lists these groups as: (1) civil servants; (2) landowners; (3) industrialists; and (4) the military.  It also talks about how these groups have become an established part of Pakistan’s political system;
• Small current account gap in February 2019 is heartening news (and bring some relief to the FX market), but additional steps are required to further narrow the external deficit.  In the 8 months so far, the trade deficit has only narrowed by 2.8% (compared to FY18) despite large PKR adjustments and the increase in interest rates;
• Most of the CA narrowing is because of lower services net payments & higher remittances;
• IMF program details should be published before it begins, and we expect the current account deficit to be around $ 12 bln for FY19, and even lower in FY20;
• Trade flows (quantum and composition) are very similar to last year, which could explain why policymakers are talking about further steps to address the BoP problem;
• With a lagged impact, Pakistan’s oil import bill should be low in the next several months, which is an ideal time to allow the PKR to adjust according to market forces;
• SBP has downgraded its growth projection to 3½ – 4% in FY19; we stay with our earlier estimate of 3%;
• A flexible exchange rate may require supportive interest rates.  We suggest a short-term interest rates hike when the PKR is floated, but rates should be reduced once the PKR has stabilized;
• While BoP actions seem clear enough, little has been done to increase fiscal revenues.  We think this is strange, and expect greater policy focus on the fiscal side as part of the IMF program;
• We also do not see a serious game-plan to fix loss-making PSEs.  We intend to get into this area of research as it will become increasingly relevant; &
• PM has stated that reducing Pakistan’s debt stock will become the PTI government’s key KPI.  This could signal the change in narrative, which is required.

This presentation was specifically prepared for a discussion at HBL, with its senior management and stakeholders.  It builds on recent papers and presentations that have been shared with our clients. 

This partial equilibrium assessment is anchored on supply-push factors that determine inflation in the country.  More specifically, we argue that the urgent need to narrow the trade deficit (given the ineffectiveness of past policies) implies that the currency would have to be further adjusted (and less strictly managed) and retail fuel prices would have to be increased. 

These price adjustments would directly impact the food, utility and transportation sub-indices, which account for over 70% of the CPI basket.  We project YoY inflation could be 12.4% by end-June 2019, while average inflation for the full year (FY19) could settle at 8.0%.  This inflationary momentum would remain in play till mid-2020.  We argue that the IMF program (and prior actions) would stoke the inflationary trend, but this is the lesser of two evils.  The real concern is what happens to interest rates. 

We argue that an orthodox approach to stabilization (i.e. increasing interest rates to keep pace with rising inflation) would: (1) create more debt servicing pressure; (2) keep the country’s market debt primarily in 3-month T-bills; (3) force GoP to continue borrowing from SBP; and (4) threaten commercial banks’ balance sheets.  None of these would help stabilize the economy. 

This creates an awkward trade-off: policy orthodox vs. actual stabilization.