February 23, 2020 (MLN): The reverse repo rate has risen dramatically from its lows of 6.25 percent in December 2017 to 13.75 percent in July 2019 as the State Bank of Pakistan (SBP) fought to rein in inflation, a leading global financial service provider Credit Suisse Group said in a report.  

In doing so, the central bank also fulfilled the policy actions required by the IMF. Rates have been held steady since then and “we do not see further rate increases on the horizon”, the report said.

With inflation remaining elevated, it seems too early for a rate cut and we believe the SBP will most likely await firm signs of disinflation before doing so. In addition, real rates remain low implying limited pressure for rates to be reduced in the near term.

Rupee

In parallel with the sharp increase in base rates, the PKR was devalued by 33 percent from December 2017 to July 2019. Most of the devaluations were undertaken in a series of 5 percent–6 percent steps and occurred against the backdrop of the government’s negotiations with international donors to bridge its estimated 12 billion dollars financing gap, Zurich-based Credit Suisse said.

The run-up to the EFF approval saw a disorderly weakening of the PKR by a further 15 percent, which we believe was driven by moves to comply with the IMF’s final prerequisites for the funding arrangement.

This was not a surprise, as the central bank governor (newly appointed in May 2019) was previously the IMF’s senior representative in Egypt, where he oversaw similar policy initiatives.

Importantly, however, the approval of the EFF arrangement triggered a slow and steady 4% appreciation in the PKR, with extremely low levels of volatility. In our view, this points to the currency being brought back under control and suggests limited downside risk, going forward.

“We expect the PKR to remain stable going forward, supported by Pakistan’s commitment to the EFF program. Thus far, the IMF’s assessment of Pakistan’s progress has been positive and on track”, the report said.

A continuation and improvement in this trend could support a modest overshoot on the REER. “We note that a move in the REER back to 105 (in line with levels seen prior to 2014) would correspond to a further 2 percent–4 percent appreciation in the PKR, according to our estimates.

Pakistan Stock Exchange

“At its trough in August 2019, shortly after Pakistan had entered the EFF agreement with the IMF, the KSE100 Index lost just under half its value vs. the peak in mid-2017”, the report said.

The stabilization in the currency and subsequent improvement in economic indicators have supported a strong 51 percent rebound in the index, decisively breaking the index out of its preceding downtrend

Forward P/E ratios have consequently moved out from deep value levels; however, they remain below their long-term average. Relative to the emerging market (EM) universe, Pakistan’s P/E ratios are still considerably undervalued.

Earnings forecasts have remained robust – even the recent spate of downgrades was not enough to push earnings momentum into contraction for any meaningful amount of time (Figure 15).

A the time of writing report (21-2-2020) the index is consolidating the recent substantive gains. Given the scale of the rally, and the subsequent normalization in exchange rates.

“We expect the index to remain range-bound near term. However, on a 12-month horizon, we see significant scope for further upside supported by earnings upgrades and cheap valuations. There is additional support from the attractive 6.4% forward dividend yield”, the Credit Suisse report said.

A key drawback for international investors, however, is low liquidity in the index. Equities as a whole saw trading volumes decline from a peak of $1.4 million daily in early 2017 to reach a post-financial crisis low of just USD 0.2 million daily in August 2019 (figures based on three-month averages). The recent rally has lifted volumes significantly, but the market is still only seeing USD 0.5 million daily.

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