July 16, 2012 (JS Research)
Pakistan's government bond rating downgrade to Caa1 from B3 by Moody's, is its lowest rating since June 1999 and seven notches below investment grade. Vulnerable external payment position, weak government finances, structural inflationary pressures and domestic political disarray are the main reasons cited by the rating agency for this downgrade. From an equity market vantage point, historical evidence shows negative market reaction (declining by an average 3%) one day post the downgrade. However, likely resumption of Coalition Support Fund (CSF) disbursement by the US, weak international oil prices, easing inflation and consensus appointment of a Chief Election Commissioner are positives that somewhat address issues raised by the rating agency. Hence, we expect market reaction to be relatively soft this time around.
What is Moody's saying…?
Moody's have downgraded Pakistan to its lowest rating since June 1999 to Caa1 and cut its outlook to negative. The reasons cited by Moody's for this downgrade are:
1) Deteriorating Pakistan 's balance of payment due to stalled export growth, decline in Foreign Direct Investment (FDI) and rising imports
2) Large repayments to the IMF in the coming years
3) Dwindling foreign exchange reserves due to worsening of external payment position, raising the probability of a default over the next year or two
4) Political instability stemming from stand off between the elected political leaders and the judiciary and constrained government finances
Is lowest rating since June 1999 justified?
1999: Moody's assigned a rating of Caa1 in June 1999 in the backdrop of a moratorium on payments to domestic creditors and restructuring of payments to external lenders, following sanctions imposed in the wake of nuclear tests conducted in May 1998. Probability of structural reforms appeared dim at the time owing to ongoing disputes with foreign investors in the power sector, the war in Kashmir and flagging domestic investor confidence.
2008: Moody's had lowered Pakistan 's rating to B3 (one notch above present Caa1) in October 2008. The rating action was due to large financing risks posed by the Pakistan twin deficits (16.3% of GDP). It was mainly a result of a flawed government policy of providing huge subsidies. Pakistan needed to enter the IMF program in order to bailout the economy from a brink of collapse. Pakistan 's Credit Default Swap (CDS) had surged to 5,106bps in October 2008, while presently it stands steady at 916bps.
2012: Although we do agree with Moody's that there are structural issues with the economy that have not been completely resolved. However unlike past instances, government has rectified some mistakes. The government has largely contained subsidies, despite this being an unpopular move among the masses in the election year. Unlike 2008, Pakistan 's real interest rate is positive and effective exchange rate not overvalued. Furthermore, Pakistan 's present import cover stands at ~18 weeks compared to 11 weeks in 2008 and 3 weeks in 1999. Looking ahead, likely resumption of CSF disbursement and weak international oil prices are likely to provide some respite to the external account. Additionally, Inflation has tapered off to 11% in FY12 from 13.7% in FY11, while government and the opposition have reached a consensus over Chief Election Commissioner. These recent developments somewhat address the concerns raised by Moody's, in our view.
Market reaction likely to be soft to downgrade
Historically, the equity market reaction to ratings downgrade has been negative (see table). However, we expect a muted reaction to the present downgrade as the concerns raised by Moody's are partially addressed. The KSE trades at an FY13F PE of 6.3x, which is at a discount of 23% to its historical 5-year average. Our top picks are POL, PPL, PSO, DGKC and NBP.
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