The headline-grabbing rally in Pakistan equities is both sensational and questionable.
Pakistan’s KSE-100 Index has registered a nearly 50% surge since late March, but it is not just impressive because it’s Asia’s top-performing stock bourse. It comes eight weeks after a deadly shooting at the Pakistan Stock Exchange in Karachi.
On June 29, four gunmen stormed the exchange in a hail of bullets and grenades. By the time it was over, eight lay dead – four security personnel and the four attackers. It quickly became an international incident, with Pakistan’s Prime Minister Imran Khan blaming India.
There’s “no doubt” New Delhi was involved, Khan told parliament a day after the tragedy, ratcheting up tensions between the two nuclear-armed neighbors already engaged in a war of words. India rejected that accusation as “absurd.”
The rally is questionable, though, for reasons that go well beyond terrorist risks in South Asia’s second-biggest economy, ones that connect to the broader global financial condition.
Firstly, though, one should note the potential for bounce back. The Pakistani exchange may be an investors’ darling at present, but volatility is sky high: Last year Bloomberg called it the “world’s worst stock market,” noting that values had halved in 2019.
And now, Pakistan equities are racing higher as the State Bank of Pakistan slashes interest rates. Although central banks are stimulating aggressively everywhere, Pakistan’s has been among the most energetic easers as Covid-19 risks savage economic growth.
Officials in Islamabad have also opened the government’s wallet, but fiscal options are limited. The government’s pre-Covid budget deficit was about 7.3% of gross domestic product (GDP).
In April, the International Monetary Fund estimated the gap would soon widen to a record 9.2% as the coronavirus fallout hits households and business demand. The central bank expects GDP growth to contract 0.4% this fiscal year, down from the 2.1% pace at which Pakistan had earlier been expected to expand.
A complicating factor is that Pakistan often carries a current account deficit on top of a fiscal one. This twin-deficits problem gives Khan’s government less fiscal space to avoid a deep recession in the next six to 12 months. It puts Governor Reza Baqir and his team at SBP in the driver’s seat.
The central bank has been steering the economy sharply in the direction of monetary accommodation. As of July, Baqir’s team has injected roughly US$7 billion into the $285 billion economy, more than 2.5% of GDP.
In June, the central bank cut benchmark rates for the fifth time since March, this time by 100 basis points to 7%.
It means that, so far, the SBP deployed 625 basis points from a lending rate of 13.25% three months ago. In their June statement, policymakers said the “domestic economic slowdown continues and downside risks to growth have increased.”
At the time, the SBP also repriced loans worth $19.5 billion that were due in early July.
“In this way,” policymakers said, “the benefits of interest rate reductions would be passed on in a timely manner to households and businesses.”
In reality, the overwhelming benefits are going to stock punters.
Pakistan punters get pumped
Undeterred by the June 29 stock exchange attack or how Covid-19 is slamming GDP and household demand, investors are on a Karachi share-buying tear.
“Expectation of a rebound in the economy and current account surplus helped the index stage a recovery,” analysts at brokerage Arif Habib Limited argued in a report this week.
Ayub Khuhro, chief investment officer at Faysal Asset Management, says his team reckons “this liquidity-fueled rally” will continue.
But isn’t that precisely the problem?
Nothing about the underlying cracks in Pakistan’s financial system have changed since the recent stock-market low in late March. In fact, coronavirus dislocations are far greater now, also challenging the view that a recovery is afoot.
Officially, Pakistan has about 295,000 coronavirus cases, not disastrous for a developing nation with 221 million people. For example, it has fewer cases than Bangladesh, with its population of 161 million.
But as an unwelcome second wave of infections surprises far more developed Asian nations, including Japan and South Korea, there’s every reason to think the IMF’s 0.4% contraction estimate is fanciful.
Granted, there are indeed “buy” signals to which the bulls can point.
One is a price-to-earnings ratio that compares favorably to peers even after the rally since March. The KSE-100 Index is trading at 10.5 times future earnings. For comparison, India’s Sensex Index is trading at nearly 29 times future profits and Singapore’s market is 19 times.
So on a relative basis, the market isn’t yet what bears would call frothy.
There is also hope for an overseas remittance bonanza to come. Earlier this month, the prime minister’s team made it easier for the Pakistani diaspora to make direct banking payments and invest in the stock exchange.
The plan, says Zulfi Bukhari, Khan’s special assistant, is to morph the overseas community into a vital stakeholder in Pakistan’s development and raise the country’s digital-banking game to suck in more capital.
Khan’s government hopes these overseas-citizen inflows also support bonds and deposits, and arm the central bank with a new source of savings to boost foreign exchange reserves.
This cohort of roughly nine million people is already a vital lifeline for Khan’s capital-starved economy. The $23 billion they sent to Pakistan last year from London, New York, Singapore and elsewhere was a larger sum than Pakistan’s earnings from exports.
The hope is that creating digital accounts that cut transaction costs will prod the diaspora to remit even more.
Finally, the government is working closely with the IMF, World Bank and other multilateral institutions to gain increased support.
As Moody’s Investors Service analyst Christian Fang puts it, there are “downside risks to Pakistan’s economy because of movement and activity restrictions related to the pandemic, which would in turn intensify the government’s fiscal challenges.”
However, Fang notes, “strong support from development partners including for external financing, coupled with effective macroeconomic policies started ahead of the crisis, contain external vulnerability and liquidity risks.”
View from the bear pit
So an economic crash probably isn’t in the cards. But then neither are the structural reforms needed to morph Pakistan into the kind of stable and more productive economy that would validate today’s extreme investor optimism.
Or to beat the “middle-income trap,” whereby per capita income stalls out below $10,000. As it stands, Pakistan’s is below $1,400.
Another big crack in the bullish case is inflation.
Though deflation is the dominant risk virtually everywhere else, Pakistan’s consumer price increases hastened to a 9.3% rate in July year-on-year, breaching SBP’s 7%-9% target range. The biggest driver is food costs, which jumped 17.8% during the months amid surging prices for wheat, sugar, tomatoes and other staples.
If the government “can’t keep this under control, they will see protests,” notes analyst Suleman Maniya of Vector Securities Pvt in Karachi.
Already, chronic food insecurity amid a pandemic upending supply chains and incomes could be an existential threat to political stability. Surging food costs have analysts at Pearl Securities Ltd predicting the central bank is done with cutting rates for now.
The trend means the “Baqir put” may be moving into the background. The reference here is to the tendency of 1990s US Federal Reserve Chairman Alan Greenspan to rescue markets at the slightest moment of turmoil.
That “Greenspan put,” of course, is forever tied to the “irrational exuberance” that led to Wall Street’s tech boom and bust in the late 1990s and early 2000s.
Momentum matters, of course. The global attention being heaped Karachi’s way is sure to fuel a fresh wave of fear-of-missing-out inflows into KSE-100 Index stocks.
And very, very clearly, Pakistan isn’t the only economy seeing a widening divergence between the health of the underlying economy and a stock market that is going gangbusters.
On Wall Street, too, powerful waves of central bank liquidity are washing away all reminders of financial cracks not so far below the surface in the real economy.
As the “Baqir put” becomes less prominent in Karachi, investors might have to rethink the forces behind the rally. Analyst Danish Ladhani of JS Global, for example, expects the stock market to “trade sideways” in the immediate future, and counsels “investors to sell on strength.”