Pakistan Exited IMF Program With Stronger Fundamentals

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Pakistan completed its 3-year $6.2 bln IMF Extended Fund Facility last year, exiting in much better shape than when it entered.  The IMF praised Pakistan for the progress it has made, but pointed to several areas that need further improvement.  These include boosting investment, increasing spending on health and education, and improving tax collection. 

POLITICAL OUTLOOK

Since the Taliban massacre of schoolchildren in December 2014, a crackdown on militants has led to a generally improved security situation.  However, tensions could rise over the status of the military’s secret courts, where accused terrorists are tried and sometimes executed.  The military was given a mandate to conduct these courts after the 2014 Taliban massacre but expired at the start of the year.

The civilian government has yet to commit to an extension.  The ruling Pakistan Muslim League (PML) said it won’t extend the mandate without a political consensus, even as the opposition Pakistan People’s Party objects to the secret courts.  A final decision is expected after the parties meet January 31.

Relations with neighboring India have cooled after a promising period of increased cooperation and communication.  Periodic violence is a major factor behind the poor relations.  Last year, Pakistan-based militants attacked an airbase in Punjab and an army base in Uri, while Indian forces mounted strikes within Pakistan.  Tensions remain high in Kashmir after the killing of militant leader Burhan Wani by Indian forces.

On the other hand, Pakistan has deepened ties with neighboring China.  The so-called China-Pakistan Economic Corridor is meant to increase infrastructure projects in Pakistan.  China is by far Pakistan’s biggest trading partner in terms of imports.  The US is Pakistan’s biggest export market.

Elections must be held by mid-2018.  Prime Minister Nawaz Sharif and his PML party are likely to win.  The first-ever transfer of power between two civilian governments happened at the 2013 elections.  The 2018 elections should cement this historic move away from military governments.

ECONOMIC OUTLOOK

The economy is picking up, but is sluggish by historical standards.  GDP growth is forecast to accelerate modestly to 5.0% in FY2016/17 and FY2017/18 from 4.7% in both FY2014/15 and FY2015/16.  Growth had remained mostly below 4% after the financial crisis.

Price pressures are low for now, with CPI rising 3.7% y/y in January.  The IMF forecasts inflation accelerating to 5.3% y/y at the end of FY2016/17 from 3.2% at the end of FY2015/16.

With inflation likely to turn and rise towards the 6% target range, we believe the easing cycle is over.  The central bank has been on hold since the last 25 bp cut back in May 2016 that took the policy rate to the current 5.75%.  The central bank next meets March 18, and no change is expected.  However, a tightening cycle could start in H2 if inflation accelerates as expected.

Fiscal policy has improved.  Under the IMF program, the fiscal deficit was brought down by removing energy subsidies, raising revenues by eliminating tax exemptions, and widening the tax base.  Also, policymakers now have a fiscal responsibility framework that caps the budget deficit whilst targeting a debt/GDP ratio of 50% (from 65% currently) over the next 15 years.

The IMF estimates that the budget deficit came in at -4.3% of GDP in FY2015/16.  It expects the gap to narrow slightly to -3.6% in FY2016/17 and then -2.9% in FY2017/18.

The external accounts are worsening modestly.  Low energy prices helped reduce imports, but not by enough to offset sluggish exports.  The current account gap was around -1% of GDP in FY2015/16, but is expected to widen to -1.5% in FY2016/17 and nearly -2% in FY2017/18.  Foreign reserves rose to a record high $24 bln in October, but have since fallen back modestly.  Still, reserves cover over 5 months of import and are about 15 times larger than its short-term external debt stock.

INVESTMENT OUTLOOK

The rupee is a heavily managed currency that is adjusted periodically.  PKR has traded around 105 since late 2015, and we look for modest weakness this year.  In its Article IV review, the IMF noted that “greater downward exchange rate flexibility would contribute to strengthening external buffers and supporting competitiveness, which has been affected by significant real effective exchange rate appreciation (about 17.5 percent over the three-year program period).”

Pakistani equities have underperformed this year after a strong 2016.  Last year, MSCI Pakistan rose 31% while MSCI Frontier fell -1%.  So far in 2017, MSCI Pakistan is up 3% YTD and compares to 8% YTD for MSCI Frontier.

Pakistani bonds have outperformed this year.  The yield on 10-year local currency government bonds is about -31 bp YTD.  This is behind only Brazil (-110 bp), Indonesia (-42 bp), Turkey (-41 bp), and the Philippines (-38 bp).  With inflation likely to pick up and the central bank’s next likely move to be a hike, we think Pakistani bonds will start underperforming.

Our own sovereign ratings model shows Pakistan’s implied rating at BB/Ba2/BB.  This suggests that there is significant upgrade potential for actual ratings of B/B3/B.  S&P upgraded Pakistan a notch back in October.