State Bank of Pakistan should reduce interest rate

State Bank of Pakistan (SBP) is scheduled to announce its Monetary Policy Statement on this Saturday (April 9th). While analysts are making all sorts of speculations certain quarters insist that SBP should reduce interest rate by 50 basis points at least. This demand is being raised after Reserve Bank of India (RBI) announced to cut the benchmark repurchase rate to 6.5 percent from 6.75 percent, the lowest since March 2011. This decision has been made despite many odds only to creating more room to face the upcoming challenges.

The options, in terms of priority, being talked about in Pakistan are: 1) maintaining status quo, 2) an increase and 3) a reduction. Some analysts fear that most probably the newly constituted Policy Board may opt for increasing the rate by bowing down before the IMF pressure. The effort will be to avoid any criticism by the lender of last resort, which is yet to release the last tranche. Keeping the IMF happy is most important because the incumbent government will have to enter into another agreement to meet its debt serving obligations.

To be honest I am fascinated by the decision of RBI chief of reducing the rate, though it may be termed notional. The logic being offered is simple, accelerating the GDP growth rate. He is not following any rocket science but the footsteps of many central banks, even the US Fed is not convinced about the interest rate hike.

The chief stated categorically that the stance of monetary policy would remain accommodative and RBI would continue to watch macroeconomic and financial developments with a view to respond with further policy action as space opens up. The present RBI chief has cut rate five times since January 2015. His option for further easing is limited due to the risk of a third straight year of below average rainfall.

It is true that pressure from the IMF is mounting on Pakistan for missing some key targets and the country may face even more stringent conditions under the new arrangements. However, the incumbent government has to come up with some home grown solutions rather than following IMF recipe blindly. This demands reduction in interest rate to facilitate fresh investment, creation of new jobs and above all improving Pakistan’s competitiveness in the global markets. The cost of doing business has to be brought down.

The cost of doing has to be brought down by reducing interest rate, bringing down electricity and gas tariffs and above all coming up with ‘business friendly policies’. The incumbent government has been enhancing tax on everything rather than catching tax evaders. Energy crisis is the outcome of blatant pilferage and non-payment of bills by certain groups.

Pakistan’s economy is plunging deeper into crisis and needs ‘out of box policies’. The focus must shift from collecting revenue to creation of new production facilities and jobs. Following the IMF recipe will not bring the country out of vicious circle of borrowing. The pace of economic activities has to be accelerated by bringing down cost of doing business and reduction in interest rate is the first step.

Pakistan Stock Market Witnesses out flow of US$9.5 million

Pakistan market regained some momentum after the PXE-100 index crossed 33,000 level during the week ended 1^st April 2016, up 1.74%WoW despite volatility from global crude trends. Activity at the market showed sharp recovery, where average traded volumes for the week rose to 140 million shares as compared to 113 million shares a week ago. Key news flows guiding the market during the week included: 1) MARI announced crude oil discovery at exploratory well Halini Deep-1 in Karak block, 2) OGRA determined price of the LNG delivered on ex-ship (DES) basis at US$8.99/MMBTU exclusive GST and allowed increase in PSO margin to 2.5% on DES price from the previous 1.98 level, 3) CDWP approved Rs218.2 billion worth of development projects including Rs129.7 billion worth of motorway construction from Halka-Burhan on M-1 to Dera Ismail Khan as part of CPEC, 4) IMF's Executive Board approved disbursement of US$502.6 million after the completion of the tenth review under the EFF arrangement, 5) MSCI released its reclassification proposal with regard to migration of Pakistan index from frontier to emerging markets, where formal is expected to take place in May’17 and 6) GoP increased the price of petroleum products taking refuge behind the recent hike in global crude oil price. Performance leaders during the week were MTL, AGTL, ABL, HCAR and DAWH, while laggards included NCL, OGDC, HASCOL, UBL and ICI. Lack of foreign interest persisted during the week with net outflows of US$9.56 million, higher than US$2.31 million recorded in the previous week.

MSCI has released its reclassification proposal with regards to migration of Pakistan index from frontier to emerging markets. While consultation with market participants will be carried out in May'16 to be followed by a decision in Jun'16, formal inclusion is likely to take place in May'17. As per the proposal, the MSCI Pakistan Index would have a potential weight of 0.19% in Emerging Markets (significantly lower than the current 9% weight in the Frontier space) with nine companies making the cut. Out of the total, three companies (OGDC, HBL and MCB) will be placed in the large cap index whereas the rest (UBL, LUCK, FFC, ENGRO, HUBCO and PSO) are likely to be placed in the Mid-cap index. Broadly meeting the set graduation criteria, minor problem areas particularly with reference to market accessibility highlighted in the document include: 1) inability of foreign investors to undertake short selling/stock lending or borrowing and 2) stability of institutional framework. Moreover, continuous shrinking of volumes during the year (1QCY16 average volumes at 134 million shares as compared to 236 million shares during 1QCY15) can potentially raise concerns on meeting the size and liquidity criteria, altering the number of constituents and weights accordingly. Hopeful for an inclusion, the market is eyeing increased visibility on the global front as a key benefit especially in the backdrop of continuous foreign selling (CYTD FIPI outflow registered at US$98 million). Also, precedence (recent entrants of other markets) indicates that market multiples can sharply expand once graduated in the Emerging Markets category.

According to the latest provisional dispatches data, cement demand remained less than impressive. Contrary to the prevailing trend, export dispatches posted the best month of the year so far with domestic demand remaining flat. On a cumulative basis, dispatches reached a record high level of +9.0%YoY in 9MFY16 as compared to +8.6%YoY in 8MFY16. Companies outperforming the industry during the month included DGKC, ACPL, MLCF and PIOC, while KOHC, FCCL, FECTC and LUCK were underperformers. On cumulative basis, KOHC, PIOC, FCCL, DGKC and MLCF continued to outpace the industry while LUCK, ACPL, CHCC and FECTC were laggards on account of loss of exports to some markets (South Africa/Iraq). While March'16 failed to keep up with the momentum, analysts expect domestic demand to pick up pace going forward on the back of higher construction activity in summers where additional positive surprise can come from any aggressive utilization of remaining PSDP funds (unutilized FY16 federal PSDP: 50%). While exports continue to decline, experts believe the recent uptick in dispatches during March'16 is encouraging. With demand expected to remain robust alongwith lower operating costs, brokerage houses maintain an Overweight stance on the sector where their top picks include LUCK and DGKC due to their ability to catch up with anticipated rising domestic demand.

Following below expected CY15 financial results and adjustment in NIMs, there is a need to revisit Bank Alfalah (BAFL). While CY15 earnings depicted the swiftest pace of growth for BAFL (earnings grew by 33% YoY), analysts do not expect such momentum to sustain as pressure on NIMs from its investment portfolio (upcoming PIB maturities worth Rs50 billion) is likely to take a toll on earnings considering lending rates are already at their multi-yearr lows.  That said, BAFL's focus on attracting current accounts (37% of deposit mix in CY16F), efficient management of its staff cost (employee/branch to go down to 15.5 in CY16 as compared to 17 in CY14) and improvement in asset quality (credit cost to come down by 21bps to 0.45% in CY16) are key factors restricting earnings decline to some extent. Additionally BAFL's push towards expanding the high margin consumer segment business (5% of loan book in CY15) can also come in handy. While dividend curtailment in CY15 was not received too well by investors, strengthening of CAR by 60bps to 13.4%, as a consequence, is encouraging making room available for BAFL to participate in the credit up-cycle. BAFL's valuation can catch up with peers through: 1) sustainable and visible improvement in the cost structure, 2) an adequate CAR buffer and 3) higher payouts.

State Bank of Pakistan could not gather courage to cut policy rate

On Saturday, 30th January 2016 the newly constituted Monetary Poly Committee (MPC) of State Bank of Pakistan (SBP) decided to keep the Policy Rate unchanged at 6.0 percent. This was a little disappointing for those, hoping against the hope. The general perception was that the MPC will find reasons for not announcing the cut, and this happened. Interesting is the review of the economy but disappointing is the decision as it shows inability of the policy makers to take an appropriate decision.

The good points of the review of economy by the SBP are as follows:

The major macroeconomic indicators continued to exhibit improvements in the first half of the current fiscal year. The inflationary environment stayed benign, LSM gained traction, and fiscal consolidation remained on track. In addition, successful completion of ninth review under IMF’s EFF and disbursements from multilateral and bilateral sources added on to country’s external buffers. With the pickup in private sector credit, for fixed investment in particular, along with improving security situation reflects strengthening of investor and consumer confidence.

Average CPI inflation declined to 2.1 percent during July-December 2015, with perishable food items and motor fuel leading the way. Meanwhile trend in YoY CPI inflation has reversed; it rose for third consecutive month to 3.2 percent in December 2015. Keeping in view the benign outlook of global commodity prices, expectation of a moderate pickup in domestic demand and further ease in supply side constraints, SBP expects the average inflation in FY16 to remain in the range of 3 to 4 percent. However, global oil price trends and excess domestic food stocks (wheat, rice, and sugar) may exert downward pressures on inflation.

Large-scale manufacturing (LSM) grew by 4.4 percent during Jul-Nov FY16 as compared to 3.1 percent in the same period last year. LSM mainly benefitted from monetary easing, falling international prices of key inputs, better energy situation, increased domestic demand for consumer durables, and expansion of construction activities. There are challenges to overall economic performance from the declines in the production of cotton and rice. However, a part of these losses could be offset by better performance of other crops, especially from the upcoming wheat crop. In view of these developments, real GDP is set to maintain the previous year’s growth momentum. The uptick in economic activity appears to continue beyond FY16 on the back of energy and infrastructure projects under CPEC.

Pakistan’s overall balance of payment position continued to strengthen during H1-FY16. The external current account deficit narrowed down to almost half of the last year’s level on account of persistent decline in international oil price and steady growth in workers’ remittances. In the capital and financial accounts, besides strong official inflows, there is some improvement in foreign direct investment.

Given depressed outlook of international commodity prices, the external current account deficit is expected to remain lower than last year. With continuation of the IMF EFF and expected disbursements from other official sources, the surplus in capital and financial accounts may increase in the second half of FY16. These are expected to have favorable impact on foreign exchange reserves. Furthermore, expected increase in FDI from China may help maintain an upward trajectory in foreign exchange reserves. Reversing of trends in exports, however, is dependent on external demand and cotton prices in international market. In addition, easing of domestic constraints with the completion of ongoing energy projects could help in improving export competitiveness.

Fiscal deficit was contained to 1.1 percent of GDP during Q1-FY16, compared to 1.2 percent in the same period last year. This reduction, despite substantial increase in development expenditures during Q1FY16, was due to improvement in tax revenues and containment of current expenditures. The improvement in fiscal accounts may continue in the remaining months of FY16. While additional tax measures announced in October 2015 are expected to contribute to growth in FBR revenues, current spending is likely to remain within target.

The year-on-year growth in broad money (M2) accelerated largely due to substantial increase in Net Foreign Assets (NFA) of the banking system. The growth in Net Domestic Assets (NDA) of the banking system decelerated despite a pickup in private sector credit. On the liability side, deceleration in growth of deposits and acceleration in currency in circulation are source of concern.

The credit to private sector increased by Rs339.8 billion during H1-FY16 as compared to the Rs224.5 billion in same period last year. The impact of monetary easing, improved financial conditions of the major corporate sector and better business environment encouraged firms to avail credit not only for working capital requirements but also for fixed investments. Going forward, the improvements in LSM, expansion plans announced by major industries and favorable monetary conditions are expected to provide continued momentum in the demand for credit.

Some stress in liquidity noticed in Q1-FY16 due to increased government borrowing from the scheduled banks steadily eased in Q2-FY16 owing to improved revenue collection and timely receipt of foreign flows. Besides this, pressures in foreign exchange market also induced volatility in interbank liquidity requirements. This is also evident from movements in overnight repo rate which mostly remained slightly above the SBP target rate.

Impact of low oil prices on Pakistan

In its latest meeting OPEC decided to maintain its oil output. This has triggered another slide in global crude oil prices. There are growing expectations that prices may remain low for longer than expected period.

One of Pakistan’s leading brokerages houses has analyzed possible implications of lower oil prices on the local stock market under three oil price assumptions of Arabian Light crude (WTI and Brent are less related to Pakistan as the country buys crude mainly from the Middle eastern countries. The brokerage house has based its analysis on three assumptions: 1) US$35/bbl, 2) US$40/bbl and 3) US$45/bbl) against its base case of US$50/bbl.

Remaining a key positive on the macro front, significant improvements are expected on 1) the BoP position on lower oil imports and 2) controlled inflation opening up room for continued monetary easing.

However, from the market's perspective this scenario will be a drag on index heavyweight Oil & Gas sector. Additionally, lower interest rates will continue weighing on banking sector's performance, however boding well for leveraged plays and high dividend plays.

Pakistan continues to benefit from lower oil prices, where another slide in the commodity's price holds positive implications for the country. Sensitivity analysis undertaken by the brokerage house indicates that with US$5/bbl reduction in CY16 will result in additional import bill savings of US$8 million/annum where oil averaging below US$45/bbl could comfortably lead to current account surplus for FY16.

Besides helping to sustain recent improvements in the BoP position, lower oil prices also have trickle down benefits on inflation, which can sustain at current levels (2.5%YoY average in CY15) across the medium term. With lower fuel costs and indirect impact on food, the sensitivity analysis indicates CY16 CPI average can hover in the range of 2.8% to 4.2%YoY.

A downwards trend in oil prices can effectively counter the low-base effect on CPI numbers, unlocking room for further monetary easing. While room could exist for a rate cut at US$45/bbl average. It is expected that the central bank may remain cautious with potential and discount rate may hover around at 5.5% at the lower extreme.

Pulled lower by falling global oil prices, Oil & Gas companies have experienced broad based selling (down 33%CYTD). E&Ps suffer from hampered profitability with POL being the most affected on account of high oil price partiality (53% of revenues in FY15). That said, the gas heavy (80%+ of overall production, 1,173mmcfd in FY14) OGDC continues to persevere in the E&P sector as its profitability is the least hurt by tumbling oil prices. Volatility in oil prices and its consequent impact on the interest rate cycle is likely to have negative implications for banking sector's profitability.

For the Big-6 banks, this is most likely to reduce CY16 earnings by 5%-18% assuming the worst case scenario. However, factors such as potential increase in the capital gains backlog and any uptick in private sector credit growth are expected to provide support to bottom-line should the interest rates come down further. In this backdrop, banks with a higher CASA ratio, greater concentration towards high margin consumer/SME segments, and higher PIB/investment ratio are expected to fare better than the rest. 

While Oil & Gas and Banks are likely to bear the brunt in case of lower oil prices and continued monetary easing, brokerage house sees cost side benefits trickling down to sectors with 1) high leverage sectors like Fertilizers, Cements and Telecom 2) higher fuel and energy costs sectors like Cements, Foods ,Shipping and Aviation.

Apart from these, Power sector is likely to benefit from reduced liquidity constraints amid lower cost of generation while a lower interest rate environment should keep the sector in limelight on account of attractive dividend yields.