Pakistan: Banking On Reform


Pakistan is one of the most under-penetrated markets for banking in the developing world. An upturn in the credit cycle, benign domestic economic conditions, and favorable demographics underpin the banks’ growth potential.

To get a sense of the growth potential available in Pakistan, consider the following: Only around 12% of the population uses a bank. As a predominantly cash-based economy, the takeup of deposit accounts and loans is among the lowest in the developing world.
As a result, private sector lending represents only around 15% of Gross Domestic Product (GDP); in emerging and frontier markets a figure of 30% plus is much more typical, and it can be even higher in several cases. For example, it is over 110% in Vietnam and around 150% in China, South Africa, and Thailand (Figure 1).

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The low penetration of banking services in Pakistan underpins an attractive, medium-term structural growth story. This is a classic example of the type of opportunity we aim to take advantage of when investing in frontier markets, an asset class that provides exposure to some of the least developed, under-researched, and fastest-growing countries globally.
We have been investing successfully in Pakistan through our Frontier Markets Equities Strategy for around three years, having been overweight since its inception in 2014. During this time, we have observed—and benefited from—a reversal of fortunes, culminating in last year’s announcement from MSCI that Pakistan will be reclassified as an emerging market at the end of May 2017.

Pakistan is a country that is coming out of the frontier universe for all the right reasons. Significant improvements in its economic, political, and security backdrop mean that a relatively volatile environment has evolved into a more stable one in which well-managed companies can potentially thrive.
Looking at these developments in more detail, Pakistan’s GDP growth rate has been picking up—the economy expanded by 4.7% in the 2015–2016 fiscal year. Encouragingly, this was driven by strong growth in the industrial and services sectors and came despite poor cotton and wheat harvests (agriculture accounts for around a fifth of the economy and a larger proportion of exports—60% of Pakistan’s sales abroad are textiles-related). Furthermore, Pakistan now has the lowest inflation and interest rates in generations and the currency has been relatively stable (Figure 2).

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Turning to the political sphere, in recent years, we have seen a government completing a full term for the first time since the country’s independence nearly 70 years ago and a peaceful transfer of power to the opposition in 2013, with Nawaz Sharif becoming prime minister following that year’s elections. The country’s three-year International Monetary Fund structural reform program has also recently been successfully completed. The level of security in Pakistan has become much better following military operations against militant groups; security remains the biggest bottleneck for sustained stability and growth, however.

The more favorable business climate has been beneficial for many Pakistani banks. A deleveraging cycle, which spanned almost five years up until the summer of 2014, has reversed sharply. Loan growth has picked up into double digits as corporates have started to releverage. This has been coming through strongly in terms of profits growth and improving margins, which we expect to continue. As was illustrated earlier, there is also a long runway for growth within the banking sector—for example, consumer lending (including mortgages) represents around 1% of GDP, while mortgages are just 0.2% of GDP.
We have been aiming to capture this through our positions in high-quality banks, two of which we have held in the Frontier Markets Equities Strategy since its inception in 2014. Both stocks have performed well in absolute terms and have outperformed the sector. We also hold another high-quality name; historically, it was the premium bank in the sector but had underperformed peers and started to look attractive on valuation grounds.
In our view, these three banks are best positioned relative to the sector. They have also been slated for entry into the MSCI Emerging Markets Index as part of Pakistan’s reclassification. We therefore expect them to benefit the most from investment flows leading into the upgrade. There is also scope for additional valuation rerating and for the return-on-equity profile to rererate when compared with emerging market banks—we would expect this to come through as the cost of equity improves with the MSCI reclassification.

A longer-term tailwind is demographics, which are likely to be supportive for the banks as well as other sectors of the economy. At around 195 million, Pakistan is the sixth most populous country in the world. It has a median age of 23 and, according to projections from the United Nations, Pakistan’s working-age population is set to grow by 2.7% per year over the next five years, while female participation in the workforce is also increasing.
Given these trends, consumer spending is an attractive structural growth story; increased use of mobile and Internet technology is raising brand consciousness—consumers in Pakistan are increasingly developing brand preferences as they become more aware of the products that they can buy. Opportunities we have identified within this space include a media company that offers good exposure to both the Pakistani consumer and the digitization of the country’s TV industry, which covers only 1% of the population.

Pakistan has been a good story for investors for a number of years, and we have broad exposure. Although Pakistan is soon to be moving out of the frontier universe, we expect to retain these holdings in the strategy until the conclusion of the investment thesis runs its course for each stock.
However, it is fair to say that the risks are building, in both economic and political terms. Inflation, although currently near trough levels, is unlikely to remain at multi-decade lows indefinitely, and while we are not expecting an inflation shock, prices will probably tick up in time, which could see a return to a tightening stance for monetary policy (Figure 3).

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We expect GDP growth to remain around current levels for the near term. Longer term, however, it is difficult to see how Pakistan can achieve “Asian tiger” levels of economic growth without even further significant economic and structural reform.
For example, Pakistan is only at an early stage in terms of the development of transport and power infrastructure, one reason being that overall investment levels have been less than half the average for emerging markets. A generally unreliable electricity supply has dogged the country for many years and has had a big impact on the textiles industry, a major exporting sector. Over the last few years, textile companies have seen their profitability hit due to frequent power cuts, which has led to underutilization of capacity. If the power shortages are fully addressed, however, a case could be made for Pakistan transitioning into a regional manufacturing base, benefiting from low labor costs and increasingly linked to the global economy.
There is cause for some optimism, though, as the China/Pakistan Economic Corridor (CPEC), a USD$46bn infrastructure plan (equivalent to around 16% of Pakistan’s GDP), is being actioned. The China-led building program encompasses projects including roads, coal-fired power stations, wind farms, and hydroelectric power. The hope is that this will help to overcome some of Pakistan’s power shortages and promote rapid industrialization and job creation.
Our visits to the country have confirmed that CPEC projects are underway and gaining momentum, with domestic demand for cement and capacity utilization recently reaching multiyear highs. The company management teams we speak to have emphasized the commercial and economic benefits that CPEC can bring, as long as the security situation can be kept in check.

Turning to Pakistan’s broader political scene, while good progress has been made, the level of risk appears to be rising. With parliamentary elections due in 2018 we could see increased government spending in the runup to the polls. In particular, we will be monitoring whether the government embarks on populist, procyclical, policies in terms of spending, debt profile and more aggressive interest rate cuts than we believe are warranted.
There are also question marks about the future of Prime Minister Sharif. Opposition parties have lodged cases with Pakistan’s Supreme Court calling for his disqualification as prime minister for allegedly misrepresenting the origins of wealth attributed to his immediate family members in the “Panama Papers” (an unprecedented leak of millions of files from the database of a large offshore law firm). There has also been speculation about his health following recent heart surgery.
While it is possible that Sharif may face political upheaval, were he to lose office before next year’s elections, our view is that the status quo would be unlikely to change, given that his PML-N party has a majority in parliament. Under Pakistan’s constitution, a new prime minister would be appointed from the PML-N (likely to be a member of Sharif’s family) who would see out the remaining term until the 2018 election.
Even if a politically-damaged Sharif loses office after next year’s elections and another administration takes power, the broad policy framework appears to be entrenched. There is general political consensus on the benefits of CPEC and the National Action Plan, which is combating extremism, terrorism, and corruption within Pakistan. Material deviation from these key policy themes seems unlikely. This is also broadly applicable to the government’s privatization program, which has promised much but so far has centered on a few sales of stakes in profitable companies such as banks and oil and gas companies. Unless the elections see the center-left-leaning PPP party take power in 2018, there is scope for this program to resume—indeed, if Sharif loses the elections to a political grouping other than the PPP, then progress could well speed up.
Overall, despite the growing risks, Pakistan’s recent success provides firm evidence of the progress achievable by frontier market countries. Increasingly, we see Asian frontier markets as a dependable source of good-quality companies trading at attractive valuations. Pakistan’s imminent return to the MSCI Emerging Markets Index follows MSCI’s upgrade of Qatar and the United Arab Emirates to the emerging universe in 2014—we believe other frontier markets have the potential to achieve emerging market status over the longer term.

Pakistan’s upcoming reclassification by MSCI marks the country’s return to the MSCI Emerging Markets Index after a gap of over eight years (it is unusual for a frontier market to be a former emerging market, another example being Argentina). MSCI’s criteria for reclassifying a country to emerging markets status are based on two factors: size and liquidity requirements and market accessibility. Pakistan was classified as an emerging markets country between 1994 and 2008, although it was downgraded following government intervention in the stock market, which effectively closed it for a number of months in 2008. Legislation is now in place that forbids the government from taking such action again. With this market accessibility issue behind it and factors such as recent privatizations having improved stock market liquidity, Pakistan now meets MSCI’s requirements to reenter the MSCI Emerging Markets Index—it will be reclassified at the end of May 2017, coinciding with MSCI’s semiannual index review. The announcement last year was received positively by investors, and saw Pakistan finish 2016 as the fourth-best-performing market in the world.


Oliver Bell – Portfolio Manager, Frontier Markets Equities Strategy – T. Rowe Price