Did Pakistan Devalue the Rupee?

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Pakistan devalued the rupee last week.  Or did it?  Accounts have been conflicting, while lack of communication between the government and the central bank warrant caution on the part of investors.  So does pending corruption charges against Prime Minister Sharif.

POLITICAL OUTLOOK

PKR was devalued last week, the first such move since 2015.  Or was it?  After the initial spike to 108.625, USD/PKR has since moved lower to trade near 105.  Before the devaluation, the pair was trading around 104.80 with little deviation this year.  We think that the rupee remains too strong at current levels and will eventually be devalued (again) in the coming months.

The currency is heavily managed, and the move last week appears to have touched off a major disagreement between the government and the central bank.  Finance Minister Dar called the rupee’s drop was caused by “miscommunication” and added “The current account deficit is the work of the finance ministry and to alter it, the State Bank is not supposed to do that.”

A new central bank governor was subsequently appointed after the devaluation.  Former Finance Secretary and tax agency chief Tariq Bajwa will be the new Governor.  He is thought to be loyal to Dar, which is likely to raise concerns about central bank independence.

The central bank has been without a governor since Ashraf Wathra’s 3-year term ended this April.  Wathra was named central banker of the year in 2016 by Euromoney and was widely respected.  However, the government declined to extend Wathra’s tenure and instead named Deputy Governor Riaz Riazuddin as acting Governor until Bajwa was appointed.

If anything, the dispute really highlights poor communication between the government and the central bank.  In most countries, a decision to devalue would most likely be coordinated, not unilateral.  It’s hard to think of any instance in which one party is so taken by surprise like this.  This bears watching.

Meanwhile, Prime Minister Nawaz Sharif is being investigated for corruption and may face trail.  An investigation began after leaked documents showed that his family had offshore accounts in Panama.  That inquiry found that Sharif was unable to account for the disparity between his wealth and his known income.  The Supreme Court will review the findings and convene a hearing on July 17.

If the court accepts the charges, Sharif may be forced to resign or be removed.  Government officials say that the charges will be fought.  Opposition leader Imran Khan called on Sharif to step down.  That call was echoed by other opposition parties as well.

The ruling Pakistan Muslim League (PML) holds a majority in parliament.  Elections are not due until the second half of 2018.  However, these latest developments call into question whether the PML can stay in power.  Political risk is clearly rising.

Corruption is clearly still an issue.  Pakistan scores very low in the World Bank’s Ease of Doing Business rankings (144 out of 190).  Same goes for Transparency International’s Corruption Perceptions Index (116 out of 176 and tied with Mali, Tanzania, and Togo).

 

ECONOMIC OUTLOOK

The IMF recently completed its annual Article IV consultation with Pakistan.  The agency looks for improved growth due to structural reforms and investment from China.  However, it warned that gains to macroeconomic stability from its recently completed EFF program were already eroding.

The economy is picking up.  GDP growth is forecast by the IMF to accelerate modestly to 5.5% in FY2017/18 from 5.3% in FY2016/17 and 4.5% in FY2015/16.  Monthly data so far in 2017 paint a mixed picture.

Price pressures bear watching, with CPI accelerating to a peak of 5.0% y/y in May before easing to 3.9% y/y in June.  This is well below the 6% target, and supports the case for steady rates for the time being.  The central bank has kept the policy rate at 5.75% since it last cut it 25 bp in May 2016.  Next policy meeting is July 15, no change is expected.

Ex-Governor Wathra introduced the central bank’s first monetary policy committee.  Whilst this was meant to address concerns about central bank independence, this week’s spat over the exchange rate suggests the government still wants to have greater influence over monetary policy.  Again, this bears watching.

Fiscal consolidation has slowed.  The IMF expects the budget deficit to narrow to -4.0% of GDP in FY2017/18 from -4.3% in FY2016/17 and -4.4% in FY2015/16.  However, it’s clear there are upside risks ahead of the 2018 election.  Indeed, Prime Minister Sharif reinstated a fertilizer subsidy earlier this year, which will likely have a large fiscal impact since agriculture makes up about a fifth of the economy.

The external accounts are likely to worsen.  The IMF sees the current account deficit widening to -3.2% of GDP in FY2017/18 from -3.0% in FY2016/17 and -1.2% in FY2015/16.  Foreign remittances have slowed recently.  On top of slowing exports, these conditions have contributed to the worsening external accounts.

Foreign reserves have steadied after falling since October.  At $21.2 bln in May, they cover about 4 months of import and are over 10 times larger than the stock of short-term external debt.

 

INVESTMENT OUTLOOK

The rupee has weakened after a steady 2016.  In 2016, PKR was basically flat.  So far in 2017, PKR is -2% YTD and is amongst the worst EM performers.  The worst are ARS (-6.5%), TRY (-3%), COP (-2%), and PHP (-2%).  Our EM FX model shows the peso to have WEAK fundamentals, so this year’s underperformance is likely to continue.

According to the IMF, Pakistan’s Real Effective Exchange Rate (REER) has been trading at record highs in recent months.  This is due largely to the fact that the rupee has been kept stable even as other currencies weaken.  The IMF noted in its Article IV consultation that “Directors called on the authorities to allow for greater exchange rate flexibility—rather than relying on administrative measures—to help reduce external imbalances and bolster external buffers.”  We think that the rupee will eventually be devalued (again) in the coming months.

Pakistani equities are underperforming after a strong 2016.  In 2016, MSCI Pakistan rose 31% vs. 7% for MSCI EM and -1% for MSCI Frontier.  So far this year, MSCI Pakistan is -12.5% YTD and compares to +18.5% YTD for MSCI EM and +14% for MSCI Frontier.  MSCI recently reclassified Pakistan as EM, following through on a decision announced last year that fueled much of that 31% rally.  We will be adding Pakistan to our EM Equity Allocation model this month.

Pakistani bonds have performed well recently.  The yield on 10-year local currency government bonds is about -32 bp YTD.  This is near the top of the EM pack.  The best performers are Brazil (-127 bp), Indonesia (-81 bp), Mexico (-67 bp), Peru (-53 bp), and Turkey (-50 bp).  With inflation likely to remain low and the central bank likely to remain on hold, we think Pakistani bonds can continue to perform well.

Our own sovereign ratings model showed Pakistan’s implied rating steady at BB/Ba2/BB this quarter after falling a notch last quarter.  There is still some upgrade potential for actual ratings of B/B3/B, but we suspect the agencies will turn more cautious in light of recent developments.