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Is erosion in rupee a blessing in disguise?

Those who have access to power corridors and also the capacity to influence government are clearly divided into two groups; 1) those consider devaluation of Pak Rupee the only option to boost exports and 2) those who term devaluation bad omen for the country. Without mincing words it may be said that first group has a very myopic view and it also fails in understanding economy. Second group view economy with wide-angle lens but being in minority they are often not liked by those having vested interest.

Pak Rupee value eroded by another 4.4% against US dollar on 20th March 2018 with interbank rate closing at Rs115.5 against US$ reflecting existing pressures on the external front and central bank’s reserves declining to US$12.13 billion. As per latest data for 8MFY18, current account deficit(CAD) surged to its highest level ever at US$10.83 billion as against US$7.22 billion for 8MFY17. While depreciation in rupee value is likely to ease off pressures on external account in the long run (weaker rupee shall restore export competitiveness apart from impeding import growth), CAD at record high levels (FY18: US$16 billion) along with declining foreign exchange reserves (SBP reserves at US$10.9 billion by June’18) can result in additional depreciation in CY18.

Expecting currency depreciation to be a key theme, AKD Securities has conducted an event based study analysis of exchange rate movements (37 devaluation events) of 21 countries, where a complete devaluation (2.5% additional depreciation from current levels, in its view) has the potential to lift KSE-100 Index by an average 30% within 120 trading days baring a few factors.

In an abrupt move, Rupee further depreciated by 4.4% against the greenback. This is the second round of depreciation during FY18 – the currency earlier lost 4.4% in December 2017. The current move reflects pressures on the BoP front, where central bank’s reserves have declined to US$12.13 billion. While depreciation of Pak rupee is likely to ease off pressures on external account in the long run, record, CAD along with declining SBP reserves can result in an additional depreciation of 2.5% in CY18. Although much of this depends upon timely materialization of anticipated inflows, where any significant inflows (news suggesting US$2billion grant from friendly countries and anticipated amnesty scheme) can help FX reserves to stabilize containing further volatility.

The event based analysis of exchange rate movements (37 devaluation events) of 21 countries and corresponding impacts on respective equity markets 260 days prior and post the devaluation event. Looking at market movements prior to the devaluation event(s), brokerage house finds that markets on average tend to come off by 33% (from peak during the review period) compounding up to the event (where KSE-100 Index retreated 28% in CY17 from its peak till currency depreciation in December 2017). In this backdrop, based on the current estimates of GDP growth rate of 5.5%, a complete devaluation (2.5% additional depreciation from current levels) has the potential to lift the KSE-100 Index by an average 30% within 120 trading days. Under a different framework, analyzing daily YoY movements, positive returns of around 10% have highest cluster based probability at 10% accompanied by positivity(where 77% of returns remained positive). In this regard, KSE-100 index has already gained 17% since mid-December 2017 with the recent round of depreciation likely to maintain the positive momentum. Beneficiaries include export oriented sectors like textiles while IPPS, E&P & IT companies benefit from their dollar linked revenues. Banking sector can also gain traction on the back of higher inflationary pressure and its consequent impact on monetary policy.

 

CAD for February 2018 slows down to US$1.24 billion (down 25.5%MoM) after peaking out in January’18 (since FY09) primarily due to ease off in trade deficit at US$2.26 billion (down 19.3%MoM) as compared to US$2.79 billion in January 218. Imports have fallen to US$4.32 billion (down 12.0%MoM) on account of decreasing machinery imports (down 20.2%MoM). This was partially offset by increase in import of petroleum products (up 5.2%MoM). However, exports remained largely stagnant at US$2.06 billion (down 2.4%MoM) gaining support from increase in food and other manufacturing exports (up 2.3%MoM) despite textile sector exports falling by 10.6%MoM. Remittances provided no relief however, recording at US$1.45 billion (down 11.5% MoM) from US$1.64 billion a month. Subsequently, 8MFY18 CAD has reached to US$10.83 billion (up 50.3%YoY) – the highest ever.

Providing a hedge against depreciation, IPPs possess the inherent ability to amplify the escalable component of their tariff structure directly impacting their bottom lines. In this case of 4.5% weighted average Rupee devaluation against the US$ in FY18 is slightly more than what analysts had incorporated their models. Adjusting for currency depreciation, the earnings forecast for HUBC and KAPCO goes up slightly by Rs0.22/share and Rs0.08/share for FY18 and Rs0.45/share and Rs0.08/share for FY19. However, given the disorderly condition of power sector with regards to overdue receivables and mounting payables, we believe this upward movement in earnings will not be tracked by dividends in the short run. That said, any possibility of cash injection by GoP will only ease up things temporarily, as structural issues persist, while a TFC issue will be unable to address the liquidity issues at hand. With this in mind, we continue to push for KAPCO with FY18/19 D/Y standing at 14.3/13.9% despite the recent run by the stock.

The recent wave of Pak Rupee devaluation had a direct impact on the profitability of IPPs. With escalable component indexed to currency movements, 4.5% weighted average rupee devaluation in FY18 is slightly above estimates of analysts incorporated in the models. The revised EPS assumption crawls up to Rs10.04 and Rs10.68 for HUBC and Rs11.01 and Rs 10.71 for KAPCO for FY18/FY19. However, analysts believe the dividend stream will not track this upward movement as liquidity issues plague sector dynamics. Moreover, the amount of foreign currency loans obtained by HUBC is insignificant posing no material risk to the company, while that of investments in subsidiaries and associates would be compensated through an adequate tariff structure which guarantees US$ indexed Return on Equity.

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