Short term gains over long term growth?

By Naween A. Mangi
Oct 26 - Nov 01, 1996

The Governor of the State Bank of Pakistan, Dr Muhammad Yaqub, announced a Rs 40 billion mini budget this past week, along with a 8.5% devaluation of the Pak rupee; just over four months after the announcement of the federal budget in June.While the tough measures in the new economic package had been anticipated by market participants through the whole first quarter, the mid term budget is being regarded with much apprehension of its longer term effects.

The additional Rs 40 billion is to be raised through cutting expenditure by Rs 27 billion and generating Rs 13 billion in revenue. Perhaps the greatest source of concern, the spending cuts are to take place primarily, to the tune of Rs 20 billion, in development expenditure, while current expenditure is to be cut by just Rs 7 billion. It is still unknown where expenditure will be cut in the Annual Development Programme, and current expenditure cuts are also unknown; Dr Yaqub’s announcement only directed federal government agencies and provincial governments to ensure "austerity and economy" in the running of their affairs.

In order to raise Rs 13 billion in additional revenue, the prices of petroleum and petroleum products are to increase by 10%, the excise duty on the distribution of gas is to go up by 10%, and Rs 2 billion is to be generated through the imposition of the agriculture tax. In addition, there will be a 2% service charge on imports which will be subject to a pre-shipment inspection by SGS and Cotecna, the income tax withholding on all supplies is to go up from 2.5% to 3.5%, the income tax withholding o imports is to jump from 4% to 5%, and the foreign travel tax is to touch Rs 1500 from the previous level of Rs 1000. Furthermore, the ordinary passport fee is to go up from Rs 800 to Rs 1500, and the urgent fee from Rs 2000 to Rs 4000, the endorsement fee will rise from Rs 100 to Rs 200 for ordinary and Rs 200 to Rs 400 for urgent, and airport tax will be 100% higher across the board- economy class will go from Rs 200 to Rs 400, business class from Rs 300 to Rs 600, first class from Rs 400 to Rs 800 and domestic routes from Rs 20 to Rs 40.

Effects on the economy

First impressions of the effect of the new package on the economy as a whole seemed to point to the direction of as recessionary path. The argument is that the price and tax increases particularly for POL products and gas would further fuel inflationary pressures (independent estimates are already at 16-17%) and the cuts in development expenditure and the fall in the value of the rupee would stagnate growth.

Analysts are optimistic about the short term effects saying that there will be a general "feel-good factor" , the IMF will most likely be appeased with the new measures and will soon release the next tranche of money. Dr Yaqub while addressing the press conference did say that both the IMF and the World Bank had supported the government’s new package although the decision was a completely independent one. In the long run however, according to one analyst, as development is cut back on, growth will slow, the devaluation and the increases in prices will reduce real purchasing power of consumers, and eventually a recession will set in. "In the short to medium term, we may have averted a crisis, but it will come back," he said.

The Winning and Losing sectors

Discussing the effects of the mini-budget on the major sectors of the stock market, Shuja Alvi, the Head of research at Global Securities said that "generally speaking all manufacturing companies will suffer." And a closer look at the measures reveals, that with the exception of a few players, most, are in for a tough time.

POL Prices: Perhaps one of the toughest measures in the new package the 10% increase in the prices of petroleum products (see table 1) will translate immediately into a 15-20% increase in power tariffs. Here, the largest gainers will be the independent power projects; the cost of furnace oil will be higher but will be a pass-along cost and not one two be borne by them. IPPs will in fact be winners all around since the devaluation will improve their US dollar-linked returns. The energy sales price according to the power policy is 6.5 cents per k Wh, and therefore while foreign investors will remain unaffected, local earnings will get a boost. Analysts at AKD Securities recommend a strong buy on Japan Power and Southern Electric, while Khadim Ali Shah Bukhari and Co (KASB) recommend Hubco and Kohinoor Energy preferring to wait on Japan Power.

Captive Power Plants, on the other hand will suffer as furnace oil, becomes more expensive and is unable to be passed on.

Another beneficiary of the POL price increase will be the oil distribution and marketing companies, PSO, Shell and Caltex, since their profit margins are linked directly with prices. Sohaib Omar, analyst at AKD Securities, said that rupee margins would further increase as the devaluation would further increase POL prices- "so they will gain all around." Pakistan’s oil imports make up about 15% of the total and total about $ 1.6 billion every year.

As in the federal budget the cement sector will once again be hard hit since fuel and energy make up about 45-50% of all production costs. The increase in POL and gas prices will squeeze margins further still, and the reduction in economic activity as a result of the cut in the development budget will further reduce the demand for cement.

Gas Prices: The 10% excise duty which has been levied on the distribution of gas will negatively affect both consumers and commercial users (see table 2). This action is also likely to fuel an increase in power rates since WAPDA is a large user of gas.

The effect on fertiliser manufacturers, according to most analysts will be positive. The 20% duty, according Sohaib Umar will not apply to these companies, and furthermore, imported urea and DAP, which is 8.5% more expensive, will now, post devaluation be even more expensive and companies will be able to increase local prices. The profitability of gas utilities , Sui Northern Gas Pipelines Limited, and Sui Southern Gas will not be affected as their returns are fixed at 17% of return on assets.

As far as pharmaceuticals are concerned, the 5% GST imposed in the federal budget has been withdrawn, but consumers are unlikely to benefit from this as pharma companies are likely to increase prices by between 6-12% in the coming weeks. Since their (imported) raw material will now cost more as a result of the devaluation, this price increase should keep their profit margins constant.

The textile sector may benefit as exports become more competitive with the devaluation, but analysts at KASB forecast that exporters will mainly gain in the short term. Textile sector analysts are generally bearish on the sector since fundamentals are weak.

For other sectors: auto assemblers will encounter more expensive CKD kits as a result of the devaluation, but the price increase ( which is likely to be slight) will be passed on to consumers and profit margins will not suffer much.

In the financial sector, banks will be able to capitalise on the short term anticipated increase in exports as a result of the devaluation.

In order to improve liquidity the State Bank of Pakistan has risen the discount rate for banks from 17% to 20%; this will push the yield curve higher and increase the cost of funds for banks, and more so for leasing companies and investment banks which generally pay 1-3% more for funds.

Furthermore, commercial banks have been given an option to convert incremental dollar deposits accumulated between October 21 and November 28, 1996 into Pak Rupees and place them with the State Bank at a fixed rate of 17%. One advantage would be that these funds would be exempted from the cash reserve requirement of 5% and the liquidity reserve requirement of 25%. When PAGE spoke to the country treasurer at a foreign bank here, he said, " I think this measure is an added incentive and will bring in swap deposits of between $ 100-300 million, and improve the foreign exchange reserve position which now stands at about $ 761 million. And since foreign banks are best able to bring in swap funds from abroad, they will be the prime beneficiaries." Swap deposits are brought in by banks under FE 45 and the SBP issues them special t-bills at the rate of libid + 0.75%. He also said that lending rates are likely to go up by 2-3% as are deposit rates for account holders.

Stock Market Outlook

As the mini-budget was announced in the late afternoon at the SBP, the stock markets reaction was being closely monitored. The KSE-100 index rose 30 points on Tuesday followed by another --- point increase the following day.

Analysts attributed this rise to two factors. Firstly, creeping devaluation gives out mixed signals to the market; this one-time 8.5% devaluation came across as a certain, unambiguous move and it sent out signals that there would not be another devaluation for some time to come. This perpetuated fresh buying, pushing the index up.

Secondly, market participants felt that some reform measures were long overdue, and the announcement of the mini-budget did generate some positive sentiment. The reason for this: the stock market is made up primarily of five or six stocks, and as one analyst said, "what happens in the rest of the market really does not matter."

Now, if we consider the effect of the fresh measures on these scrips, a trend become evident; PTCL is likely to be positively impacted as foreign revenue received in dollars would result in greater rupee earnings, HUBCO, like other IPPs discussed earlier will also gain as they pass along the furnace oil p[rice increase and gain on dollar-linked returns, and the fertiliser players, Engro Chemical and Fauji Fertiliser will also gain as discusses. Perhaps the only loser here would be ICI; since the $ 196 million loan for the PTA project is unhedged against devaluation, the cost of the project, according to AKD Securities, will go up by Rs 617 million, assuming the loan has been disbursed.

So largely the effect of the mini budget on the major stocks is positive, and this drove the index to rise.

Suhaib Umar forecast that the short term outlook for the week or ten days post-announcement would be quite good with the market rising to the levels of 1470-80, subsequently either falling or stabilising at those levels.

Another market analyst said, "I think the market will go down after the short term gains fade, because the real economic impact will become evident and it will come to light that we are heading towards a recession."

The stock market therefore, is riding on the reaction of the IMF and their decision in the coming weeks, and Moody’s decision on the sovereign rating of Pakistan; if they do downgrade, we are likely to see selling pressure once again and more troubles for the market, but if they do not, some stability may set in.