PAK - PAK: Structural Issues In Pakistan Continue Despite IMF Bailout

2023-07-10 11:26:26 ET

Summary

• Pakistan's economy, which is heavily reliant on debt, is facing issues such as high inflation and a weakening currency. The country's debt to GDP is high and increasing, and its GDP has been contracting since 2018.
• Political instability in Pakistan has also contributed to the country's economic problems. No Prime Minister in Pakistan's history has served a full term, and recent social unrest has further destabilized the country.
• Pakistan is now on its 22nd IMF loan, and the IMF has demanded an interest rate hike from the central bank.

I've been seeing a trend in frontier and emerging markets whereby countries take on too much debt to grow and then either default or inflate it away as the debt was unproductive. About two months back I covered this issue in Turkey, where for a long time the government had an expansionary fiscal policy to boost the financial economy into a crack-up boom. This caused asset prices to go up but also caused a weak currency and large amounts of consumer price inflation. In this situation, the country can't raise rates without putting the economy into a deep recession or keeping rates low and continuing high inflation. Essentially, they are stuck between a rock (hyperinflation) and a hard place (deep recession and potential debt default).

Even though I first noticed this issue in Turkey about two years back when my first article on it came out, I have since seen that this behaviour is exhibited in many other frontier and emerging market countries like Pakistan, providing me with a framework that I can use for many countries.

Issues In Pakistan

No write-up about the Pakistani markets can be had without discussing the political turmoil there. Since Seeking Alpha isn't a political/policy website, I'm not going to do a deep dive; instead, I'm going to provide a high-level overview and for anyone interested in learning more I will provide links to other sites where more information can be found.

Pakistan has had a history as a failed state. To the point where there hasn't been a single prime minister in its history who has stayed a full term. Since the GFC, the economy in Pakistan has been stagnant. The 2010s were stagnant for Pakistan as growth was slow due to a commodity bear market as the country is dependent on both industrial and agricultural commodity prices. This caused twin deficits to grow and the currency to weaken, all while both the government and the private sector were taking on more debt. This has caused worsening political tensions. Recently the pandemic has caused Pakistan's textile industry, which is its biggest industry, to go into a downturn. 2021 was a comeback year, but then in both 2022 and 2023, the economy worsened. This has also come amidst a no-confidence vote in April 2022 when populist Imran Khan was removed from office largely because he broke support with other parties and most important the military; this was the start of social unrest which continues to this day.

Here are some links ( 1 , 2 , 3 ) to learn more about the current political crisis and the history behind it.

An Economy Built On Debt

The biggest issue in Pakistan is the debt burden, which is leading to many other issues like high inflation.

Below is a chart of debt to GDP :

As can be seen, debt to GDP is very high and growing. While Pakistan already had a lot of debt, to begin with, its GDP has contracted since 2018.

The GDP contraction from 2018-2020 caused the government to stimulate the economy through more spending via expansionary fiscal policy. This caused more debt due to excessive fiscal spending and a growing trade deficit.

When a country, especially one with an already weak currency, has large and growing twin deficits along with a low overnight rate, inflation ensues. This is because twin deficits bring more debt and a more high-velocity broad money supply, while low rates cause devaluation on the FX market.

Inflation :

This puts policymakers in a bind where inflation can continue to run hot, or they can raise rates and cut spending, causing an economic contraction. For dollar/hard currency-based equity investors, neither of these scenarios is good.

IMF Bailout

Pakistan is now on its whopping 22nd IMF loan. In my opinion, this is now starting to turn into a situation where Pakistan is borrowing from Peter to pay Paul. This is evident with a high debt-to-GDP ratio; with GDP likely to contract and debt to grow, this figure will, in my opinion, go higher.

Here is what the IMF had to say about the most recent deal :

I am pleased to announce that the IMF team has reached a staff-level agreement with the Pakistani authorities on a nine-month Stand-by Arrangement (SBA) in the amount of SDR2,250 million (about $3 billion or 111 percent of Pakistan's IMF quota). The new SBA builds on the authorities' efforts under Pakistan's 2019 EFF-supported program which expires end-June. This agreement is subject to approval by the IMF's Executive Board, which is expected to consider this request by mid-July.

As said above, the agreement is for 3 billion USD. Under this deal, Pakistan has committed to have a fiscal surplus of 0.4% of GDP and to raise its overnight rate to 22%.

Parliament has approved FY24 budget in line with the goals of supporting fiscal sustainability and mobilizing revenue, which will enable greater social and development spending. The FY24 budget advances a primary surplus of around 0.4 percent of GDP by taking some steps to broaden the tax base and increase tax collection from undertaxed sectors, as well as improving progressivity, while ensuring space to strengthen support for the vulnerable through the BISP program. It will be important that the budget is executed as planned, and the authorities resist pressures for unbudgeted spending or tax exemptions in the period ahead.

I think this deal is much ado about nothing. First off, Pakistan's annual budget is $50.4 billion and its GDP is $348.3 billion. A 0.4% GDP surplus on the budget is $1.39 billion. The surplus is extremely small in relation to the budget, and I could easily see the government spending more than it estimated or the treasury receiving less in taxes than expected.

Above is the government budget deficit as a percentage of GDP. As can be seen, it is usually in the high single digits since the GFC. Because of this, my view is that Pakistan would need many years or a decade-plus of budget surpluses in the high single digits to remove the issue of fiscal expansion causing high-velocity inflation and currency devaluation. Its current budget surplus is nowhere close to this.

The big kicker with this deal is that the IMF demanded an interest rate hike from the central bank. My view is that Pakistan is likely to continue to take more IMF loans, as that is what history shows us. In the future, the IMF will likely demand even higher rates to curb inflation. As rates go higher, I expect that this will cause equities to go lower; the biggest reason being that the interest rate acts as a hurdle rate, so if equities aren't returning above that amount then they are likely to go lower.

Central Bank Rate :

Balance of Trade Crisis

Another major issue that this IMF deal doesn't solve for the balance of trade crisis .

Above is the Pakistani balance of trade. As can be seen, the balance of trade has been deeply negative for the last decade; in fact, when looking at a longer-term balance of trade chart, the trade balance has been negative since 2004 but has gotten significantly worse over the last couple of years.

This has caused a drop in Pakistan's FX reserves :

As Pakistan's FX reserves go lower, the Pakistani Rupee needs to be sold to buy more foreign currency. This furthers the devaluation of the Pakistani Rupee against hard currencies. The current IMF deal does nothing to stop this issue from persisting.

Valuations Aren't As Cheap As They Seem

As you can tell from my view on the IMF bailout and the various political issues in Pakistan, I still believe there is a long way to go till I get bullish on the economy or structural issues.

The big pushback that I will get from many is that the valuation for the Pakistani market is low, hence this is all priced in, and in fact, many might see this as a deep value play.

A lot of retail investor websites use cookie-cutter valuation methods such as a P/E ratio. Using just a P/E ratio to tell if an asset is "cheap" already has a lot of issues, but it gets even worse in distressed frontier market investments due to FX risks, changes in rates, volatility in inflation causing earnings to be volatile, political risks, etc.

One of these websites that uses a cookie-cutter valuation method is Simply Wall Street . Below is the current P/E ratio on the KSE (Most Extensive Pakistani Market Index) and a 5-year average P/E ratio on the KSE.

I would caution against using this approach to justify that the Pakistani market is "cheap". Once various factors are taken into account, it can be seen that the Pakistani market is fairly valued at best.

First off, with the risk-free rate now at 22% equities would have to yield significantly higher to justify buying them. At a 4.9x P/E, the earnings yield is slightly above 20%, which is less than the risk-free rate.

The second issue with valuation is that earnings are likely to go lower in USD terms. First off this is because Pakistan's GDP has been contracting, and with now higher rates and a fiscal surplus, I see this continuing. The second issue is that even if earnings are growing in Pakistani Rupee terms, they are contracting in USD terms due to the consistent devaluation of the Rupee.

This brings a triple threat to investors: a higher hurdle rate causing lower earnings multiples, lower earnings in real terms, and currency risk.

This does bring up the question of why the Pakistani equity market is richly valued. The simple explanation for this is that locals have nowhere else to put their capital. They can continue to hold onto Rupees that are losing 35%+ per year to inflation while earning only 22% interest on them, or they invest in the equity market where companies can raise prices on consumers to give their shareholders a real rate of return. Investors will choose the latter option as it preserves capital better during periods of high inflation. There is often no other option due to currency controls and the difficulty that locals face when getting capital out of Pakistan.

We've seen something similar in other countries like Turkey where the equity market is up big time in Lira terms but is down in USD terms.

Since most of the readers on Seeking Alpha and myself are hard currency investors who look at our returns in USD or other stable currencies and don't face the same issue as those in Pakistan, it wouldn't make sense for us to buy into Pakistani equities at this time. In fact, the opposite trade of shorting Pakistani equities that are priced in USD would make sense. This can be done by shorting the PAK : Global X MSCI Pakistan ETF.

The Bottom Line

The bottom line here is that Pakistan continues to face structural issues causing high inflation and large twin deficits. I don't believe the recent IMF deal will do much to solve it. Moreover, basic valuation metrics make the Pakistani equity market look cheap when in fact is it likely a value trap for hard currency-based investors.

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