ARTICLE (February 19 2009): An estimated US $1.4 trillion has been wiped out from global banking capital, implying that around US $17.5 trillion of lending capacity has evaporated. This is equivalent to one-third of Global GDP of US $55 trillion. No wonder the IMF and World Bank are sounding alarm bells. We expect global real GDP growth to be below 2% for the next three years.
As the international financial and economic order undergoes a tectonic shift it would be naïve to assume that the global political order will remain the same once the dust settles. With significant structural weaknesses in fiscal and external account arenas, the near-term prognosis for Pakistan's economic growth is weak. That is the bad news.
The good news is that Pakistan's "fall from grace" for investors was much earlier than other emerging markets and the country was forced to adopt, via IMF-deal, a more disciplined economic policy. Early indicators are very positive regarding policy traction but Pakistan is not out of the woods yet. Continued austerity is likely throughout 2009, which should form the basis of a V-shaped recovery in 2010 rather than a prolonged U-shaped trajectory in the absence of fiscal and monetary discipline.
We forecast 3.5% plus real GDP growth in FY09 rising to near 4.6% in FY10. The aggregate demand compression policies will keep interest rates high and general liquidity tight until 2H2009. Thus, the Pakistan stock market is likely to remain range bound between 4,500-6,000 levels for the next quarter or so. However, this 30% range provides opportunities for stock picking and active investment strategies.
GLOBAL RECESSION: In order to understand the nature and severity of the global financial and now, economic crisis, we just need to see what has happened to the international banking system and then assess its consequences. By IMF estimates, over US $2.2 trillion capital has been wiped out from the international banking system in just over a year.
We estimate that US $1.2-1.5 trillion is linked with direct and indirect losses due to exposure to US mortgage derivatives (sub prime) and general real estate linked financing/securities. Given an average Tier-1 Capital Asset Ratio (CAR) of banks as per BIS guidelines of 8% (itself a conservative estimate!), this implies that around US $27.5 trillion lending capacity of the international banking system was wiped out.
We estimate that OECD Governments, via unprecedented bailouts, have pumped in US $800 billion of new capital into their banks. That still leaves a capitalisation gap of US $1.4 trillion or reduction in lending of US $17.5 trillion. To put this into context, note that global GDP is estimated at US $55 trillion. The evaporation of US $17.5 trillion lending is equivalent to a third of global GDP (32%).
No wonder the IMF and World Bank are sounding alarm bells regarding the global economic outlook. IMF expects global GDP to grow by a meager 0.5% in 2009 against 3.4% in 2008 - this is the lowest growth since World War II. To be sure we are rather intrigued by the IMF's 3.0% global GDP growth forecast for 2010. In our view, the world will be lucky to achieve even 1.5% GDP growth in 2010. As they say, "You ain't seen nothing yet!"
With the collapse of US real estate values, the American consumer - mainstay of global demand for quite a while, thanks to Greenspan - has been highly affected. And with adverse effects of the banking system's systematic clog-up, loans to normally healthy businesses are being affected. Forget long term financing; simple working capital loans are not available.
Global trade is shrinking rapidly and not simply due to a crash in demand in OECD but also because importers' banks are simply not opening Letters of Credit (LCs). Smaller banks which are still opening LCs are finding difficulties in having them confirmed by the bigger international banks. This is not all; with the US consumers facing large-scale job losses the credit card lifestyle is suddenly pushing them towards economic despair.
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Potential Outperforming Sectors in 2009
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Sector Comments
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1.TELECOM (PTCL) Significantly below
estimated intrinsic value
2.FERTILIZER (FFC, ENGRO) High yield, strong fundamentals
3.POWER GENERATION (HUBCO) High yield, strong fundamentals
4.SELECTED BANKING (NBP, MCB, HBL) Significantly below
estimated intrinsic value
5.PAPER/PACKAGING (PAKAGES) Non recurring event,
Long term positive
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Source: Alpha Beta Research
Between car-lease securitization and credit card securitization there is another couple of hundred billion dollars of financing that is rapidly becoming infected.
CRISIS HAS SPREAD: At the same time, with OECD imports falling rapidly, Asian exporters are now facing gale-force winds. It has been estimated that each 1 ppt reduction of US GDP growth leads to over 6 ppt reduction in China's exports.
As a group, the so-called next economic powerhouse block of BRIC countries (Brazil, Russia, India and China) is expected to fare poorly over the next 2 to 3 years relative to their past decade's economic performance. Already, Chinese officials estimate that 20million people have become unemployed.
China's case, in particular, is important because as China became the workshop of the world it also became the key export destination for many Asian component manufacturers whose components were packaged into the final product in China. So there is a domino effect that these Asian economies will have to contend with. Finally, going up the supply chain, raw material/commodity producers are seeing sharp fall in demand and their export prices are collapsing.
Opec's much touted huge foreign currency reserves will shrink more rapidly than consensus estimates. Russia has just spent US $200bn of its reserves to try to create an orderly depreciation of the Ruble which has effectively collapsed. The US is pressing Arab members of Opec to give the IMF US $300-400 billion to cushion the global lender's tightening liquidity despite Japanese pledge to provide US $100 billion support.
THE WORLD: All in all, the global financial order is undergoing a tectonic shift. Underlying it is the global economic order, beneath which lies the global political order. It would be naïve to suppose that the underlying realities will remain intact as before, once the dust settles on this crisis. In Europe, the law and order crisis in Greece and industrial unrest in France and Spain are probably the first manifestations of frustrations that are building up in the world's second largest economic bloc.
Even Russia has not been immune to public protests against the ruling administration. While we do not agree with those who predict dramatic shift in global political power soon, we do expect gradual but persistent move away from the US Centric World seen in the first decade of the new millennium.
This will involve not just economic consequences of regional economic blocks becoming more important, it will also provide a test of will for dominant global political powers to retain their unchallenged supremacy. In other words, we are likely to live in an even more volatile international political environment than previously and that means global co-ordinated economic policy making will become all the more difficult as each economic block attempts to protect its own interest.
ENTER THE RANGE BOUND EQUITY MARKETS: At the same time, in the near term, OECD Policy initiatives, including another phase of bailouts of the banking systems and specific industries, are coming thick and fast. With average interest rates in OECD at historic lows, the classic Keynesian "liquidity trap" appears to be in force where monetary policy has literally lost all traction.
Hence so much focus on recapitalizing the banking system and initiating massively expansive fiscal policies in the OECD. Yet, it remains to be seen whether all this stimulus will create positive economic momentum in the near term. We believe it will not. Wealth destruction has occurred on an unprecedented scale, and now income destruction is accelerating.
The "bottoming-out" of the global economy will take perhaps two to three years, what to speak about a pick-up. Investors are realising that bull market of the "goldilocks era" is now gone and unlikely to be seen for a very long time. Investors need to attune themselves quickly in successfully navigating the bear market in the short term and find opportunities in a largely range bound equity market environment well into the medium term.
IMPLICATIONS OF THE GLOBAL RECESSION FOR PAKISTAN: As a country with significant structural weaknesses in the fiscal arena as well as external accounts, the near-term prognosis for Pakistan's economic growth is relatively weak. In that light international rating agencies' low country rating is understandable. That is the bad news.
The good news is that the rating agencies' record has consistently been extremely poor in predictive terms. Invariably, their calls appear to be near term (last 3-6 months) backward looking rather than medium term (12months) forward looking. Our perspective on Pakistan's economy is somewhat different. As a result, our risk perception is much lower than one based on rating agencies' views because in our assessment Pakistan is more poised for a V-shaped recovery than many emerging economies.
An analogy would be about 'fall from grace'. The high flying poster-child countries of the emerging markets universe have had the largest fall from "investor perception grace" which, we believe, is still to continue for some while yet. Pakistan's political turmoil, starting in mid-2007, led to its falling from grace much earlier. The only other country in a similar predicament has been Thailand.
And precisely because of this reason, in Pakistan at least, the crisis created necessary conditions for IMF support and more importantly, its imposed discipline which was missing in the political government.
STRUCTURAL IMBALANCES: We assess that the fiscal discipline now in place in Pakistan will start showing itself in key indicators by 2Q2009.
Already, there are clear signs of improvement in the fiscal balance and current account position, while core inflation is definitely on a deceleration trend as seen over the last six weeks' figures.
The challenge for financial policy makers now is how to balance the CROWDING OUT of the private sector that has occurred and is occurring due to demand compression policies now in place. Upto 1HFY09 (July-December 2008), private sector credit expansion was negative 27.6% versus 1HFY08 (PKR 178bn versus PKR 246bn). In terms of growth in FY08-09 (ending June2009) we expect real GDP growth to come out near 3.5%, driven largely by a robust agricultural sector and decent showing by the services sector.
Industrial sector is bearing the brunt of economic slowdown and is likely to post one of the highest declines in recent history in excess of 8%. This reality is now dawning upon our economic managers, who have begun looking at sector specific relief packages via bank loan restructurings and easing security valuation requirements.
In our view the new Governor of the central bank has taken the appropriate approach of keeping general liquidity tight but providing industry specific relief focusing on productive and export oriented sectors. However, we also feel that the quantum of support has to be substantially higher in order to make any real difference in the face of enormous pressures on key exporting sectors.
By our estimates the non-inflationary GDP growth capacity of the Pakistan economy is in the 5.0-5.5% region. With private sector demand significantly curtailed there is need for public sector to take up the slack. However, the government's fiscal space is very constrained over the next six months due to support programs for lowest (and hardest hit) income groups and high cost of war against extremists.
As such, bilateral (govt. to govt.) and multi-lateral (IMF, World Bank, ADB, IDB) lending is likely to drive public sector funding in the foreseeable future (next 12-24 months). Many analysts and commentators are very skeptical regarding significant inflows from foreign governments in the near term, such as the Friends of Pakistan Forum, or the now defunct Biden-Lugar Bill in the US Congress and the cancelled US $5.0 billion UAE refinery project in Pakistan.
In our assessment, the current delays have more to do with management of the financial and economic crisis in donor countries rather than any strategic shift. We therefore feel that international strategic imperatives, combined with demonstrated better housekeeping by Pakistan will result in significant development oriented funding for Pakistan over the next three years. In that context, we believe that Investors should focus beyond the media headlines towards regional and global mega-trends to assess the probability of governmental and multi- lateral fund flows to Pakistan.
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Macroeconomic Environment in 2009
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GDP growth Below trend
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Fiscal deficit Significant improvement
Trade deficit Import reduction led narrowing
C/A deficit Improving with remittances support
Core inflation Decelerating
Forex reserves Stable
Exchange rate 3-5% depreciation in CY09
Interest rates Peaking out, lower in 2H09
Private sector demand Subdued
Development spending Sharply lower
Aggregate demand growth Decelerating
Tax revenue collection Near target levels
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OVERALL PROGNOSIS On the mend, but not out of the woods yet
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Source: Alpha Beta Research
POLICY CHOICES: Some of the key structural changes necessary to provide sustainable revenue are related to taxation and governance. In the former, it is imperative to significantly improve documentation of the retail and service sectors, while bringing agriculture, real estate and capital markets under the tax net to start with. 70% of Pakistan's population is rural.
As a result, the major constituency of parliamentarians is agricultural. It remains to be seen how the finance ministry can make real headway in agricultural taxation in such a situation. The second area is governance. Various sources estimate that anywhere between 30-50% of development expenditure is leaked via mismanagement, poor planning and outright corruption. If any progress - even small steps - is made on this front, the proportionate impact on availability of fiscal space will be large.
Skeptics say that one should not have any expectation from the government on the above fronts as we have all seen the economic "non-performance" of both the PPP and PML in the "nineties-decade" when the productive capacity of the country was significantly reduced. We cannot argue with facts.
What is said was indeed the case. Yet we are believers in democracy and feel that once the democratic process gets established the electorate will, overtime, put more representative parliamentarians in the assemblies. The press is also hugely free now than in the 1990's. It has already acted as a source of checks and accountabilities in a host of cases related to governance and public sector management.
This is a good tradition and with time it will also become more effective. In conclusion, our take is that while the global economic turmoil is a significant challenge for Pakistan, given that (a) exports comprises only 14% of GDP and (b) the country's external funding has been and remains largely in the bilateral and multi-lateral domain, Pakistan economy will likely bounce back to 5% - 6% over the next two fiscal years.
With per capita GDP at nearly US $1,000/-, even this growth should be sufficient to allow corporate sector revenue growth to bounce back from FY08-09 shock of policy driven demand compression.
STOCK MARKET OUTLOOK: The stock market as a whole is likely to remain range-bound between 4,500-6,000 in 1H2009, due to continued liquidity constraints and political uncertainty caused by law and order situation as well as upcoming Senate elections in March 2009.
Specific segments and sectors of the stock market should however begin to reflect greater visibility of FY10 earnings by mid 2009. That is when we believe the market - helped by reasonable likelihood of reduction in interest rates - is likely to show sustainable direction.
In the meanwhile, even the KSE-100 range of 4,500-6,000 implies 33% volatility band - good enough in a range-bound market for trading oriented investors who have done their homework on fundamentals of specific companies. So which companies; What entry levels; What target prices? These are the questions on investors' minds. For the purposes of this report, in our opinion, potentially outperforming sectors (in terms of total return) with below average risks, between now and December 2009, are likely to be:
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