Of all the factors that are currently driving the
asset prices in Pakistan, improving risk perception is probably the most
important. The shift in investors' risk appetite has provided the
necessary foundation for liquidity to work its magic. In itself,
liquidity is impotent. In itself risk is not important either. It is the
perception that matters.
We have examined the relationship between risk and
equity prices and our findings show a significant correlation that has
some interesting implications.
EIU RISK SCORE
Economist Intelligence Unit (EIU) publishes country
risk scores that are based on a fairly standard methodology currently
being used in sovereign credit risk modeling. An outline of the process
is shown in Figure 1. The approach is comprehensive and objective.
A sample of country scores is shown in Figure 2. As
of December 2004, Pakistan is ranked 73rd out of a universe of 100
Figures 3 & 4 chart EIU Risk Scores versus the
KSE 100 Index. Equity performance and risk are the Siamese Twins.
Sentiment trumps fundamentals.
As we write, the index is close to 6000 level. Based
on the fitted fair value curve in Figure 4, this implies a Risk Score of
52. The market is optimistic about the future of Pakistan Inc. For the
moment, it is also willing to put its money to back it up.
Bond Prices have information about issuer specific
risk that can be a very useful indicator. We prefer to look at Stripped
Spreads (Bond Yield — Benchmark US Treasury Yield) on the dollar
denominated debt to assess a clean measure of sovereign credit risk.
PK Republic 6 3/4% 09 is a dollar denominated
Pakistan bond (issued February 2004). The bond is benchmarked to 5Y US
Treasury. The daily Stripped Spread on this bond is plotted versus the
KSE 100 Index in figures 5 & 6.
TWO ASPECTS JUMP OUT OF THESE PICTURES:
significant part of the move in the equity prices can be explained by
the improving risk profile (falling yield spread).
2. Bond prices
are a useful leading indicator for KSE 100 performance.
The third measure of risk we have studied is the
Agency Ratings. S&P have upgraded Pakistan from B to B+ as of 22
November 2004. Moody's is widely expected to follow in the New Year.
This will make borrowing cheaper for the government and the corporate
sector in the international capital market. We are back to our 1994
ratings via downgrades in late 90's and a default. It has been a fair
effort by any definition.
In theory, every indicator suggests that current
asset valuations can be sustained. Except, that is, for one: Pakistan
These lads represent the national psyche and
character only too well. At one level we know this is true. The emotion
that goes with an ordinary game tells us that this is no game. This is
the serious and painful business of self discovery. Pure genius
interrupted with self destruction. It is awesome and mindless.
No risk measure can begin to capture our ability to
self distract. It borders on genius; and it is awesome; and it is
mindless. The coming year will show if we can live with our good
(For Figures kindly refer to
our Magazine hard copy)