Pakistan: Balancing risks and rewards

For most investors, Pakistan is largely defined as being highly volatile, be it in terms of security, politics or the economy. And in many ways, it is. However, Charles Sunnucks, Assistant Fund Manager, Emerging Markets, argues there is increasing evidence of positive structural change in the country, which in turn has created some of the most compelling long-term bottom-up investment opportunities of any asset class.

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Pakistan is considered by many to have a highly fragile economy due to its current account and budget deficit. The country has received IMF support 12 times since 1988, and many corporates believe another IMF package is inevitable. However, substantial corrective measures are being taken to tackle structural imbalances.

The budget deficit is being corrected using both policy carrots and sticks to broaden the tax base. Due partly to a relatively heavy taxation regime, receipts account for only 12.6% of GDP, an improvement from 9.3% in 2011, but below half that of many other emerging economies. This phenomenon is largely a consequence of a huge informal economy estimated to be around the same size as the formal one. Measures have already started with the 2017 capital gains tax reduction, and in 2018 a tax amnesty on unregistered assets and reduction in corporate rates are anticipated. This is significant for corporates, as tax reform will provide not just financial benefits to profitability, but also an operational advantage for those already in compliance.

In terms of the structural current account deficit, this is largely due to a heavy reliance on foreign energy imports, namely oil. Policy makers have however already started investing heavily in a very ambitious energy reform program focused on shifting power generation from highly expensive oil to coal, hydro and solar; meaningfully reducing import reliance. Moreover, as energy blackouts become less of an operational risk, investment in domestic manufacturing should grow. In the past decade Pakistan has had only three foreign car manufactures.

Yet in the past year, three more companies are looking to start operations, partly due to improved generation capability. For corporate Pakistan, this will create many opportunities, but heavy investment in equipment has created short-term pressure on the current account balance due to the importation of foreign machinery.

The growth of financial inclusion

Banking in Pakistan is unique as unlike the corporate/consumer lending model of most banks worldwide, Pakistani banks largely favour government lending. This has been achievable due to the substantial spread between retail saving rates and government debt, allowing banks to balance good profitability with stability. In terms of broader system leverage, there is very limited consumer or corporate debt.

This however is changing, and borrowing is becoming increasingly acceptable, a tailwind that will likely support a positive loan growth outlook for many decades to come. More striking is the opportunity in retail deposits. Currently only around 13% of Pakistani’s have a bank account, and of the total accounts only 14% are held by females. As the informal economy reduces, and savers become more educated about wealth management, this should be an area of substantial growth. The experience of markets such as Indonesia has been that banks which can couple robust loan and deposit growth with a level of profitability in excess of their cost of equity, can increase multi-fold through the initial stages of bank sector development. Despite this, leading banks in Pakistan trade at valuations below half that of their regional equivalents.

As banks develop, other opportunities in financial services will be created. For instance, insurance premiums in Pakistan remain below 1% of GDP, less than a fifth of levels in China, Thailand and Malaysia.

Evolving consumer preferences

Over the past fifty years, Pakistan’s political instability and security concerns have stunted economic development. However, the last ten years have been Pakistan’s longest period of civilian rule since founding, and the last elections marked the first peaceful transition of power, helping to improve the security situation. A large part of the border with Afghanistan is now fenced, financial support for religious extremism has been reduced, and lawlessness in the cities has been largely resolved.

As a result, consumer confidence has increased, creating new opportunities for corporate Pakistan. For example, the country has a population of over 200 million, but just four malls. As retailing shifts from markets to modern retail formats, companies can more readily establish brands with pricing power. Consumption is also changing. Take Pakistan’s growing milk market: only 10% of milk is pasteurised, a number which should reach near 100%.

Growth in consumer confidence will also support the housing market. Currently, housing finance in Pakistan is only 0.5% of GDP, relative to around 10% for their neighbour India. The prospects for housing should also benefit from the transition to reduced household sizes.

At present, an average household has three rooms and six occupants. However, the trend towards greater individual independence from a younger age will likely put pressure on the current level of housing.

The rise of Chinese ’soft power’ in Pakistan

Pakistan has a rich history and is a complex mix of western influence, Islamic beliefs and growing Asian connections. The most notable change in this respect, is the fast-developing relationship with China. Via the so called ’China Pakistan Economic Corridor’ program, a part of the Chinese ‘one belt one road’ initiative, China is investing substantial amounts to support Pakistan’s infrastructure projects. Year to date over 67% of foreign direct investment in Pakistan is from China. Trade with China is now to the extent that the Pakistani central bank is actively considering using the China Rmb as a reserve currency rather than the USD, a move that would have been entirely unthinkable only a few years ago. The consequence of this shift is that there are now far more aligned economic interests in Pakistan, and infrastructure is being built on a historic scale.

For corporates, infrastructure projects vastly improve their ability to do business across the country, opening new domestic markets and improving supply chains. Over time, the outcome will likely be that regional leaders consolidate into national champions.

Entirely overlooked by many, attractive opportunities have emerged

The equity market in 2017 was largely characterised by substantial foreign investment outflows and the MSCI index elevation from frontier to emerging market status. 2018 has so far been noticeable for the two currency depreciations by the central bank, a 10% depreciation against the dollar which had been largely considered as long overdue. Going forward into the year, a potential final decision on a tax amnesty in the coming months, and national elections in August will likely attract global investor attention. While there may be near-term uncertainty, longer-term trends are far clearer. The equity market remains below 40% of GDP, around one third the size of most other Asian markets, and as the informal economy is reduced this differential is likely to reduce.

For equity investors, Pakistan will likely remain a cocktail of opportunities and risks. Positive structural change may not benefit all businesses, and development will not be a smooth journey.

However, in a market entirely overlooked by most investors, this fast moving landscape will likely provide attractive bottom-up opportunities for some time to come.

Charles Sunnucks May 2018

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