Life with IMF & its Likely Impact

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1 Pakistan Equity Economy Update April 03, 2018 REP 057 Life with IMF & its Likely Impact Topline Research Tel: Topline Securities, Pakistan Best Local Brokerage House Brokers Poll , Best Local Brokerage House

2 Table of Contents Executive Summary IMF Program on the Horizon and 2013 IMF Programs Key Indicators Under 2008 & 2013 IMF Programs IMF Likely Conditions and Impact PKR-USD Estimated to Reach Rs136 by June Interest Rate Likely to Reach 8.75% by June Reserves & Import Cover to Improve Post IMF Program CPEC Activity and IMF Program GDP Growth to Slow Down Post IMF Program Key Macro Forecasts in light of IMF/Reform Measures Foreign Assets Amnesty Scheme Index can reach 50,000pts Banks and E&Ps likely beneficiaries Pakistan Economy 2

3 Executive Summary Pki Pakistan s External Account woes continue to worry investors as outlook on Foreign Exchange (FX) reserves and Current Account Deficit (CAD) seems alarming at a time when Pak US relations are not good. Pakistan s FX reserves are down 40% to US$11.8bn as of March 22, 2018 (2.6 months of import cover) since its peakof US$19.5bn in Oct2016. With this situation, there are three possible scenarios that can unfold: 1) strict measures including further PKR devaluation and interest rate hike, 2) entry into IMF s program and 3) bailout from friendly countries. We are of the view that the first two scenarios will likely unfold where the Govt. will take strict measures and enter an IMF program in 2H2018 post general elections. However, the intensity and after effects on economic activity of IMF bailout will not to be as profound as witnessed post 2008 and may not be as mild as seen after the 2013 program. Pakistan can avoid knockingki IMF s door, thoughh probability bilit of it happening is low, if the Govt. manages to arrange decent external financing from friendly countries (China & Saudi Arabia) by 3Q2018 along with taking corrective measures. Considering our base case where Pakistan will seek IMF funding, we anticipate further devaluation of 10% in FY19 and 7% in FY20 which is likely to take PKR/USD parity from current Rs115 to Rs136 by FY20. We also anticipate SBP policy rate to be increased from current 6.00% to 8.75% by FY20 under IMF program. With reform measures, CAD will likely clock in below 3% of GDP by FY20 vs. 5.1% expected in FY18 & foreign exchange reserves will improve to US$15bn by FY20 vs. US$11.8bn as of Mar 22, While we expect CPEC to continue, measures under IMF program could affect projects progress to some extent. Pakistan Economy 3

4 Executive Summary Due to aforesaid reasons, Pakistan s GDP growth is likely to slowdown to 4.6% in FY19, 4.7% in FY20 and 5.1% by FY21 as against 5.7% of growth expectations in FY18. Timing and quantum of currency devaluation, policy rate hike and smooth transition of democratic government (GeneralElections likelyl in Jul2018) will be key triggers for themarket. t We maintain our index target of 50,000 pts by Dec 2018 with PE range of x, which we had mentioned in our Dec 2017 Pakistan Strategy report. The market is currently trading at 2019F PE of 8.3x. We have Overweight stance on Banks, E&Ps & Textile sectors that are likely to be beneficiaries of policy rate hike and currency devaluation. Key Economic Indicators FY17A FY18E FY19F FY20F FY21F FY22F FY23F GDP Growth (%) 5.3% 5.7% 4.6% 4.7% 5.1% 5.1% 5.1% PKR/USD June end Inflation (%) 4.2% 4.0% 7.0% 7.5% 7.5% 7.0% 7.0% Imports (US$bn) as per SBP Exports (US$bn) as per SBP Current Account Deficit (% GDP) 4.1% 5.1% 3.8% 2.4% 2.1% 1.9% 1.8% Foreign Direct Investment (US$bn) Foreign Exchange Reserves (US$bn) June end end Fiscal Deficit as % GDP 5.8% 5.8% 5.0% 4.7% 4.7% 4.4% 4.4% Source: State Bank of Pakistan; International Monetary Fund; Topline Research Pakistan Economy 4

5 IMF Program on the Horizon Pakistan s External Account woes continue to worry investors as outlook on FX reserves and CAD seems alarming. FX reserves held by Pakistan s Central Bank have come down from US$16.1bn in beginning Jul 2017 to 3 year low of US$11.8bn as of Mar 22, This equates to around 2.6 months of import cover ascompared to last 5 year average import cover of 3.5 months. CAD during 8MFY18 has climbed to US$10.8bn and is anticipated to clock in at US$15.6bn (5.1% of GDP) in FY18. The external account situation is worst than our expectation. Moreover, investors are also concerned with worsening Pak US relations and recent Foreign Action Task Force (FATF) grey listing of Pakistan. Given the severity of situation, investors are concerned over how the issue will be resolved and how it can affect the currency and market. There are three likely scenarios that can unfold: 1) strict measures including further PKR devaluation and interest rate hike, 2) entry into IMF s program and 3) bailout from friendly countries. We are of the view that the first two scenarios will likely unfold where the Govt. will take strict measures and enter an IMF program in 2H2018 post general elections. Pakistan Honda Atlas Economy Cars (HCAR) 5

6 IMF Program on the Horizon An IMF program will bring financial discipline and help reduce pressures on FX reserves as we think Pakistan can secure US$6 7bn of IMF loan, out of which US$2 3bn can be disbursed in FY19. We expect IMF bailout package to be an Extended Fund Facility (EFF) for a period of 3 years. With IMF s support, other lending agencies will also feel comfortable to provide funding to Pakistan. IMF support is not new. Pakistan has attained 21 IMF programs in 60 years, with the recent most programs in 2008 and We believe that the intensity and the after effects of the IMF program will not to be as profound as witnessed post 2008 and may not be asmild asseen after the 2013 program. In our view, Pakistan can avoid knocking IMF s door (though probability of it happening is low), if the Govt. manages to arrange external financing from friendly countries (China & Saudi Arabia) by 3Q2018. Along with funding from friendly nations, the Govt. will have to take corrective measures (less intense than they would be under an IMF program) like currency devaluation, increase in interest rates, increase in tax rates/duties, privatization of state owned entities and reduction in power sector subsidies to avoid going into IMF program. Pakistan Economy 6

7 2008 and 2013 IMF Programs In Nov 2008, IMF approved US$7.6bn Standby loan for Pakistan. This was due to abysmally low FX reserves of US$3.5bn (1.6x imports) with high CAD in FY08 of 8.2% as % of GDP compared to 4.5% a year ealier. Post IMF program, five years later in 2013, Pakistan went into another IMF program (EFF) during Sep 2013 given extremely low foreign exchange reserves of US$3.0bn (0.8x imports) during that year acquiring US$6.6bn of loan. Foreign Exchange Reserves Trend and IMF Programs US$mn SBP FX Reserve Imports Cover Months 20, ,000 12,000 IMF Program IMF Program , , Jan n-06 Dec c-06 Oc ct-07 Sep p-08 Ju ul-09 May y-10 Ap pr-11 Feb b-12 Jan n-13 Nov v-13 Sep p-14 Aug g-15 Jun n-16 Ap pr-17 Ma ar-18 Source: State Bank of Pakistan, Topline Research Pakistan Economy 7

8 Key Indicators Under 2008 & 2013 IMF Programs External Current Account Deficit improved post IMF programs Fiscal Deficit on lower side post IMF program % GDP 9.0% 7.5% 6.0% 4.5% 3.0% % GDP % % - FY06A FY07A FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15A FY16A FY17A FY06A FY07A FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15A FY16A FY17A Source: State Bank of Pakistan, Topline Research Source: Economic Survey, Topline Research GDP Growth showed mixed trend during IMF programs Inflation more a function of local demand/supply factors 7.0% 5.6% 4.2% 2.8% 18% 15% 12% 9% 6% IMF Program 1.4% 3% 0.0% 0% FY06A FY07A FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15A FY16A FY17A FY06A FY07A FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15A FY16A FY17A Source: Economic Survey, Topline Research Source: State Bank of Pakistan, Topline Research Pakistan Economy 8

9 IMF Likely Conditions and Impact The macro implications of new IMF program could bemilder than what was seen post However, it could have more profound implications as compared to what happened back after IMF guidelines usually entail tighter monetary/fiscal policies. Currency devaluation, discount rate hike, reduction in subsidies, higher energy tariff and increased tax measures are some of the key policy measures generally used under the IMF program. IMF also encourages countries for reforms and privatization of public sector entities so it could reduce fiscal burden. IMF recently in May 2017 approved Extended Fund Facility (EFF) for Mongolia with total package of US$5.5bn. As part of the reform process in Mongolia, IMF has stressed on fiscal consolidation through cut in non essential expenditures and move for progressive taxation. It has also stressed the importance for market determined exchange rate that could help Mongolia address external account concerns. In July 2017, IMF approved 1.6bn stand by agreement for Greece and is focused on broadening the income tax base and reforming pension spending to rebalance the budget toward more growth friendly policies. Furthermore, program also promoted steps that reduces high NPLs in the banking sector. Pak Rupee against the USD has already weakened by 10% in FY18 to date. We anticipate further devaluation going forward. Interest rate is up 25bps in last 3 months and we expect these to increase further. Increase in tax rates, privatization of state owned entities and reduction in power sector subsidies are also likely to be the part of IMF reform process. This will assist itgovernment to reduce fiscal dfiit deficit which h is anticipated i t to clock in at 4.7% of GDP by FY20 vs. 5.8% in FY18. Pakistan Economy 9

10 PKR USD Estimated to Reach Rs136 by June 2020 We expect PKR USD to reach Rs136 by June 2020 under IMF program as we anticipate further devaluation of 10% in FY19 and 7% in FY20. This will be pivotal to arrest demand led import growth in the country and will also be a part of IMF reform process which focuses on more flexible and realistic exchange rate to address external account concerns. This would also be in line with the Real Effective Exchange Rate (REER) Index, which we currently estimate at around 110 index level. This has averaged at 106 during the last 10 years. The below graph clearly indicates that when REER index rises there is a need for currency devaluation due to movement in other currencies (of trading partner countries). REER Index vs. PKR-USD parity Index Number REER PKR USD % Change % 4.0% 00% 0.0% -4.0% -8.0% Jul-0 05 Apr-0 06 Jan-0 07 Nov-0 07 Aug-0 08 May-0 09 Mar-1 10 Dec-1 10 Oct-1 11 Jul-1 12 Apr-1 13 Feb-1 14 Nov-1 14 Sep-1 15 Jun-1 16 Mar-1 17 Jan-1 18 Source: State Bank of Pakistan, Topline Research Pakistan Economy 10

11 Interest Rate Likely to Reach 8.75% by Jun 2020 Under IMF SBP is likely to gradually increase interest rates by 275bps to 8.75% by FY20 under IMF Program from the current 6% in order to curb spiraling aggregate demand and imports of the country. This will also keep positive spread (real interest rates) over inflation rates as average inflation is anticipated to reach 7.5% in FY20 from 4% in FY17. During the recent two IMF programs of 2008 and 2013, interest rates have usually been higher than inflation to maintain positive spread. This helps contain demand pressures and restrict the country s twin deficits of external account and fiscal account. Real interest rates during the 2008 IMF program averaged 1.4% while during the 2013 IMF program averaged 3%. Discount Rate vs. Inflation over the Years 30.0% Discount Rate 25.0% 20.0% 15.0% Inflation IMF Program 10.0% 5.0% IMF Program 0.0% Jan-0 06 Feb-0 07 Feb-0 08 Feb-0 09 Feb-1 10 Feb-1 11 Feb-1 12 Feb-1 13 Feb-1 14 Feb-1 15 Feb-1 16 Feb-1 17 Feb-1 18 Source: State Bank of Pakistan, Topline Research Pakistan Economy 11

12 Reserves & Import Cover to Improve Post IMF Program Foreign exchange reserves of thecountryisanticipated ii to improve to US$16bn by FY21,which h is equal to 3.6 times of import cover versus current foreign exchange reserves of US$11.9bn, close to 2 months of import cover. These are expected to fall further to around US$9bn by June 2018 incase of non materializationof flows. This will primarily be driven by gradual inflows of US$7bn under the IMF program during the next 3 year. Furthermore, reform measures that include interest rate hike and devaluation would also lead to improvement in CAD. We anticipate CAD to improve from an expected US$15.6bn (5.1% GDP) in FY18 to US$7.6bn by FY21 (2.1% of GDP). Current Account Deficit to improve US$bn Current Account Deficit CAD as % of GDP % 4.5% 3.5% 2.5% 1.5% 0.5% Import Cover to Cross 3.5x of Imports US$bn Reserves Import Cover 18.0 FY15A FY16A FY17A FY18E FY19F FY20F FY21F FY15A FY16A FY17A FY18E FY19F FY20F FY21F Months Source: State Bank of Pakistan, Topline Research Source: State Bank of Pakistan, Topline Research Pakistan Economy 12

13 CPEC Activity and IMF Program It is possible that the CPEC projects (both infrastructure and power projects) may be affected to accommodate for strict measures under IMF program. However, as per our channel checks, geo political implications of CPEC may restrict the extent of IMF s concerns on this front. In our report titled Pakistan s External Account Concerns and CPEC Repayment published on March 10, 2017, we had estimated average annual repayment of CPEC will be US$3bn over the life of CPEC from FY Further, between FY20 25, we had estimated range of US$ bn with average payment of US$3.7bn. Due to some delay in projects, implementation and subsequent repayments may be lower than earlier estimates. The ability to repay for Pakistan will depend upon rise in exports on the back of better infrastructure and better availability of power because of the CPEC projects. CPEC Repayment Avg. Annual No. of Total Repayment (US$bn) yrs (US$bn) Repayment over life of CPEC (FY20 49) Medium term (FY20 25) 25) Source: Topline Research Pakistan Economy 13

14 GDP Growth to Slow Down Post IMF Program As a result of currency devaluation, interest rate hike and other measures, Pakistan s GDP growth is likely to slowdown to 4.6% in FY19, 4.7% in FY20 and 5.1% by FY21 as against 5.7% of growth expectations in FY18. This will be led by slowdown in Manufacturing Sector growth which constitutes around 20% of the total GDP. We anticipate growth in Manufacturing sector growth to average 4.5% vs. last 3 year average growth of 6%. On the other hand, services sector will post growth of 5% in line with its last 3 year average led by growth in financial services. Agriculture growth is anticipated to average 3% in line with last 3 year average of 3%. IMF in recently released staff report has also opined that GDP growth may fall to 3% in FY19 in case sufficient foreign flows do not materialize. GDP Growth over the years and IMF program 6.0% 5.0% 4.0% IMF Program 30% 3.0% 2.0% 1.0% IMF Program 0.0% FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23 Source: State Bank of Pakistan, Topline Research Pakistan Economy 14

15 Key Macro Forecasts in light of IMF/Reform Measures FY17A FY18E FY19F FY20F FY21F FY22F FY23F GDP Growth (%) 5.3% 5.7% 4.6% 4.7% 5.1% 5.1% 5.1% GDP (US$bn) GDP/Capita (US$) 1,629 1,630 1,670 1,723 1,784 1,847 1,913 PKR/USD June end SBP Policy Rate (%) June end 5.75% 6.50% 8.25% 8.75% 8.75% 8.00% 7.50% Inflation (%) 42% 4.2% 40% 4.0% 70% 7.0% 75% 7.5% 75% 7.5% 70% 7.0% 70% 7.0% Imports (US$bn) as per SBP Exports (US$bn) as per SBP Trade deficit (US$bn) as per SBP Current Account Deficit (US$bn) Current Account Deficit (% GDP) 4.1% 5.1% 3.8% 2.4% 2.1% 1.9% 1.8% Foreign Direct Investment (US$bn) Net Ext. Fin. (excludes debt repayments) (US$bn) Foreign Exchange Reserves (US$bn) June end Total Public Debt as % GDP 68% 71% 72% 73% 72% 72% 72% Fiscal Deficit as % GDP 5.8% 5.8% 5.0% 4.7% 4.7% 4.4% 4.4% Source: State Bank of Pakistan; International Monetary Fund; Topline Research Pakistan Economy 15

16 Foreign Assets Amnesty Scheme Pakistan is expected to launch Foreign Assets tax Amnesty Scheme to lure its nationals to bring back their foreign assets to Pakistan. Govt. is targeting to introduce Indonesia like tax amnesty scheme. As per news reports, Pakistanis can legalize their foreign assets by paying reportedly 2% 7% tax on their foreign assets. Indonesia during 2016 had announced such a tax amnesty scheme. The tax amnesty scheme resulted inflows of around US$10bn in the Indonesian economy while the total amount declared was US$340bn by early This, in our view, could result in one time foreign inflows and ease pressure on the foreign exchange reserves. The Prime Minister s aide on Revenue, Senator Haroon Akhtar has recently said that Pakistanis could repatriate up to US$5bn under such scheme. In 2017, Bloomberg quoted tdsyed Muhammad Shabbar Zidi Zaidi s (partner at A.F. Ferguson & Co., an affiliate of PricewaterhouseCoopers LLP) assessment that Pakistanis hold US$150bn in undeclared offshore assets. Out of this, US$$80bn are parked in property and bank deposits, US$20bn in local stocks held in foreign accounts and US$50bn in assets such as manufacturing concerns. Pakistan Economy 16

17 Foreign Assets Amnesty Scheme Taking cue from Indonesia and above estimates of Pakistanis assets abroad, a similar tax amnesty in PakistancouldfetchuptoUS$3bn,whichwehaveassumedinourforecastsforFY19andFY20.This assumes that around 10% of the liquid assets will be brought back in Pakistan. Other than foreign flows, an amnesty scheme is expected to lead to increased documentation and higher taxes. To mention, Supreme Court (SC) is also diligently pursuing the matter of assets held by foreigners abroad and has constituted a 12 member committee (headed by the SBP governor) to suggest measures to retrieve such assets and to stop unregulated outflow of foreign exchange from the country. Pakistan Economy 17

18 Maintaining Index Target of 50,000pts We had forecasted that KSE 100 index can reach 50, pts by Dec Please refer to our strategy report titled, Pakistan Market Outlook dated Dec 20, Since our report, KSE 100 index has rallied 13% (8% in US$). We are maintaining our target of 50, points. We believe that the market will likely trade in the PE range of x, as mentioned in our above stated strategy report. Market is currently trading at 2019F PE of 8.3x, based on our sample companies. Forward Market PE During Past IMF Programs (X) IMF Program IMF Program Jan n 06 Sep p 06 Jun n 07 Feb b 08 Nov v 08 Aug g 09 Apr r 10 Jan n 11 Sep p 11 Jun n 12 Mar r 13 Nov v 13 Aug g 14 May y 15 Jan n 16 Oct t 16 Jun n 17 Mar r 18 Source: Bloomberg, Topline Research Pakistan Economy 18

19 Banks and E&Ps likely beneficiaries Timing i and quantum of PKR devaluation, increase in policy rate, civil iil& military relationship and smooth transition of democratic Govt. (General Elections likely in Jul Sep) will remain key triggers, we believe. PKR devaluation and higherh interest t rates will help Banks and Oil & Gas Explorers while anticipated increase in exports should draw investors interest to Textile, in our view. Pakistan Stock Market: Key Numbers 2015A 2016A 2017A/E 2018E 2019F 2020F PE Earnings Growth 2% 8% 10% 10% 14% 9% PBV Dividend Yield 5% 5% 4% 5% 5% 6% ROE 18% 15% 13% 14% 16% 17% Source: Topline Research Pakistan Economy 19

20 Analyst Certification and Disclosures The research analyst(s), denoted by an AC on the cover of this report, primarily involved in the preparation of this report, certifies that (1) the views expressed in this report accurately reflect his/her personal views about all of the subject companies/securities/sectors and (2) no part of his/her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. Furthermore, it is stated that the research analyst or its close relative have neither served as a director/officer in the past 3 years nor received any compensation from the subject company in the past 12 months. Additionally, as per regulation 8(2)(i) of the Research Analyst Regulations, 2015, we currently do not have a financial interest in the securities of the subjectcompany aggregating more than 1% of the value of the company. Rating System Topline Securities employs three tier ratings system to rate a stock, as mentioned below, which is based upon the level of expected return for a specific stock. The rating is based on the following with time horizon of 12 months. Rating Expected Total Return Buy Stock will outperform the average total return of stocks in universe Neutral Stock will perform in line with the average total return of stocks in universe Sell Stock will underperform the average total return of stocks in universe For sector rating, Topline Securities employs three tier ratings system, depending upon the sector s proposed weight in the portfolio as compared to sector s weight in KSE 100 Index: Rating Sector s Proposed Weight in Portfolio Over Weight > Weight in KSE 100 Index Market Weight = Weight in KSE 100 Index Under Weight < Weight in KSE 100 Index Ratings are updated daily to account for the latest developments in the economy/sector/company, changes in stock prices and changes in analyst s assumptions or a combination of any of these factors. Valuation Methodology To arrive at our 12 months Target Price, Topline Securities uses different valuation methods which include: 1). Present value methodology, 2). Multiplier methodology, and 3). Asset basedmethodology. Research Dissemination Policy Topline Securities endeavors to make all reasonable efforts to disseminate research to all eligible clients in a timely manner through either physical or electronic distribution such as , fax mail etc. Nevertheless, all clients may not receive the material at the same time. Disclaimer i This report has been prepared by Topline Securities and is provided for information purposes only. Under no circumstances this is to be used orconsidered as an offer to sell or solicitation of any offer to buy. While reasonable care has been taken to ensure that the information contained therein is not untrue or misleading at the time of publication, we make no representation as to its accuracy or completeness and it should not be relied upon as such. From time to time, Topline Securities and/or any of its officers or directors may, as permitted by applicable laws, have a position, or otherwise be interested in any transaction, in any securities directly or indirectly subject of this report. This report is provided only for the information of professional advisers who are expected to make their own investment decisions without undue reliance on this report. Investments in capital markets are subject to market risk and Topline Securities accepts no responsibility whatsoever for any direct or indirect consequential loss arising from any use of this report or its contents. In particular, the report takes no account of the investment objectives, financial situation and particular needs of investors, who should seek further professional advice or rely upon their own judgment and acumen before making any investment. The views expressed in this report are those of Topline Research Department and do not necessarily reflect those of Topline or its directors. Topline as a firm may have business relationships, including investment banking relationships, with the companies referred to in this report. All rights reserved by Topline Securities. This report or any portion hereof may not be reproduced, distributed or published by any person for any purpose whatsoever. Nor can it be sent to a third party without prior consent of Topline Securities. Action could be taken for unauthorized reproduction, distribution or publication. Pakistan Economy 20

21 CONTACT US Mr. Mohammed Sohail CEO Dir: +92 (21) Research Team: Mr. Saad Hashemy Chief Economist & Director Research Dir: +92 (21) Mr. Umair Naseer Deputy Head of Research +92 (21) Mr. Nabeel Khursheed Senior Research Analyst +92 (21) Mr. Rai Omar Basharat Research Analyst +92 (21) Mr. Shankar Talreja Research Analyst +92 (21) pk Mr. Fahad Qasim Manager Research +92 (21) Mr. Asif Habib Database Officer +92 (21) Equity Sales Team: Mr. Muhammad Rizwan Head of Sales Dir: +92 (21) Ms. Samar Iqbal Head of International Equity Sales Dir: +92 (21) Mr. Muhammad Hammad Aman Senior Manager Equity Sales Dir: +92 (21) Mr. Kumail Raza Senior Manager Equity Sales Dir: +92 (21) Mr. Haris Kunda Senior Manager Equity Sales Dir: +92 (21) Corporate Office: 508, Continental Trade Center, Block-8, Clifton, Karachi, Pakistan Tel: Fax: Pakistan Economy 21