May 25 - 31, 2009

The festival of San Fermin, or the Pamplona bull running as it is more commonly known, takes place in Spain every summer.

After nudging our 8,000 index target, the KSE-100 Index has dropped 7.7% since CYTD peak on April 20, 2009. Post result sell-off, concerns over ethnic tribulations in Karachi and rising insurgency have led to high volatility, with net negative performance over the past three weeks. On the average, April performance has fallen within historical trend, with the Index up 5% on the month. Recent corporate showing has largely been mixed - some good, some bad and some ugly. As a result, immediate-term market direction over the next month or so is likely to hinge on the balance of civil order against ethnic wrangling, build up on pre-budget expectations and headway in the Army's offensive against militancy. At the same time, sequential earnings, valuation gap and market rerating triggers should set the floor if domestic law & order deteriorates. This should provide an opportunity to capitalize on a post-budget rally, particularly if market transaction costs remain unchanged. That said, downside risk to a post-budget rally remains on account of an unnecessary push to increase revenue collection. Given the IMF fiscal benchmarks for FY10, we think there exists limited room for increasing total budgetary outlays.

Geopolitics - Taking decisive measures: After the attempted peace deal based on the controversial hybrid Islamic law "Nizam-e-Adl" (Justice Regulation) went sour, rising tensions between the Government and militants have led to a decisive call on the Pakistan Army to undertake a full scale operation to rout out insurgency. Coalition partners and opposition have expressed support for full-scale military engagement, announced by the Prime Minister late last week. Niche support for the Taliban looks to be waning with the recent rise in vindictive Taliban conduct. While it remains premature to gauge the fallout of army intervention, potential reactionary militant backlash remains a key risk. Aid agencies have estimated additional displacement to reach 500,000 people, which would take total displacement from affected areas to 1mn over the last 12 months.

US-Pak Relations: The Prime Minister's national address coincides with President Zardari's visit to the US and developments on the proposed tripling of non military aid to Pakistan. On the sidelines of the trilateral summit in Washington, the 2009 Supplemental Appropriations Bill approved US$1.9bn (US$591mn above the request) for Pakistan for the next fiscal year to help address the economic crisis and strengthen national and provincial governance among others. The amount also includes US$400mn Pakistan Counterinsurgency Capability Fund (available by September 30 09), to be used to provide targeted aid to Pakistan's military. Urgent US assistance coincides with expressions of support for Pakistan army action against Taliban insurgents, and indicates the willingness of the Obama administration to provide both short and long-term assistance.

Micro politics - Karachi Tribulations: While political parties amicably called off respective strikes for May 12, 2009, hostile statements coming out of the camps of the MQM and ANP have kept apprehension levels high in Karachi. The MQM has threatened to leave both the Provincial and Federal Governments if the Sindh Government fails to alienate the ANP on alleged ties and support of the Taliban. The ANP has retaliated by calling for Army action against the MQM similar to the operation against the party during the nineties. If political confrontation steps onto the streets of the Country's Financial Capital, investors could overlook positive underlying developments. .

The Budget - Performance review: Taking a flashback on how the budget has weighed in on the market, we thought it would be interesting for investors to review past market trend in the run-up to the budget announcement as well as post-budget market behavior. Market performance pre-budget during the last 5 years has been mostly negative on market taxation expectations. A doubling of transaction costs in 2006 led to an 11.5% and 4% pre and post budget correction. However 2008 is an exception where despite capital gains tax exemption the market posted a negative 9.5% and 10% return pre and post budget underpinned by a broad deterioration in macro metrics and political bickering. Over the past 5 years, the market has shown a positive move three times, with considerable upside rally witnessed on two occasions (stock exchange side stepping the tax net). This time around the budget poses downside risk if we see an unnecessary push to increase revenue collection. However, we see limited room for increasing fiscal spending in FY10 given the tight medium term budgetary targets set by the IMF. In addition, the phasing out of subsidies should keep a lid on pressures on the revenue enhancement side, in our view. (Our Economist Asad Farid follows up with a detailed Shadow Budget FY10 later in this report).

The Market - Investment Strategy: While geopolitical developments and budgetary measures pose both upside and downside risk, any negative move should be limited and provide an opportunity to capitalize on likely market re-rating, in our view (the market has lost 7.7% from its CYTD peak over the last 3 weeks). Sequential earnings outlook and prevailing valuation gap should set the floor on the downside (see annexure for corporate performance review and sequential outlook). Word on the street is that NIT has received a new disbursement as part of its SEF and has been cherry picking at lower levels in the mandated eight stocks. Furthermore, market hearsay suggests that the Apex regulator is considering in-house leveraging which should add to market liquidity, volumes, and foremost, sentiment. MSCI is also expected to make announcement this month placing Pakistan in the Frontier Index. This should serve as the first step to pulling back portfolio flows, in our view. On the macro side, indicators continue healing with April CPI and Core inflation down to 17.1%YoY and 17.7%YoY while future foreign lateral flows should continue providing space on the external side. This should underpin future rate cuts in monetary policy and boost the overall re-rating process. However, re-rating will likely dovetail the overall risk profile as the Pakistan Army makes headway on its full-scale military operation in Swat and adjoining areas.


Economist/Investment Analyst


In the backdrop of heightened security risks and a nascent political setup, the domestic economic managers have indeed been set a momentous task to 1) revitalize the prevailing anemic level of economic activity, 2) maintain macro stability, 3) spur development spending necessary to upgrade failing/obsolete infrastructure and 4) carry out reconstruction activities on a fast track basis. The budget for FY10 would certainly require a fine balancing act and major fiscal restructuring, given a weak resource base - a result of the domestic economic slump & a regressive taxation structure - and limited fiscal flexibility under the IMF's financial program which mandates that the fiscal gap is kept south of 4.6% of the GDP. That said, the likely high level of bilateral aid flows which should start flowing-in during FY10 should contribute towards keeping the fiscal side in order and allow the GoP to commit higher funding levels for defense and development expenditures.

We at AKD Research believe that the GoP can undertake necessary mega development works - especially in the power/hydel sector - and at the same time keep the fiscal side balanced, "if" resources are utilized efficiently. This, in our view, can be achieved through non traditional practices like "zero based budgeting" to stem excesses and hence curtail the resource gap & bank borrowing requirement of the GoP.

We have attempted to devise a "Shadow Budget" for FY10 on a similar pattern as was done for FY09 in our report titled "THE SHADOW BUDGET FY09" dated 10th Jun'08. In our base case scenario analysis, we try to judge whether the IMFs fiscal benchmarks for FY10 can be met under the assumption of real GDP growth of 4% & inflation averaging 9% in the next fiscal year.


* Revenue generation of PkR1.85tn is achievable; out of which tax generation of PkR1.28tn is possible. Though this figure is higher than the projected level of PkR1.136tn for FY09, it will be significantly lower than the IMF target of PkR1.5tn.

* External budgetary financing will most likely be in excess of the IMF projection of PkR140bn for FY10, considering the high level of financial support shown by both bilateral & multilateral donors recently for Pakistan. We project external budgetary assistance to stand at PkR328bn in FY10.

* Total debt servicing will likely eat away 52% of resources allocated for current expenditures in FY10 as compared to an average of 36% during FY05-FY08. With NSS rates averaging at 13.6% and yields on government paper only marginally lower than peak levels, servicing the expensive domestic debt taken post FY07 and repaying the IMF market based loan will likely keep debt servicing burden high over the next two years. However, as the interest rate environment eases going forward and the expensive debt segment gradually gets paid-off, we expect the debt servicing burden to normalize from FY12 onwards.

* We forecast development expenditures of PkR514bn (higher than IMF projection of PkR140bn) in FY10, which will be substantially higher than the estimated level of PkR187bn in FY09. In our view, the GoP might be compelled to prioritize development investment considering the urgent need to buildup existing inadequate power/water infrastructure in order to address the looming water crisis.

* Despite the sharp anticipated decline in the subsidy burden which is projected to reduce to around PkR20bn in FY10 as compared to PkR217.2bn in FY09 and PkR407bn in FY08, we project current expenditures to increase by around 8.7%YoY in FY10 as compared to only 1% rise likely in FY09. This would occur due to a projected increase in non-discretionary spending on defense and debt servicing in FY10.

* If actual resource generation and fiscal outlays are inline with our projections then the total financing gap will be around PkR684bn, i.e. 4.5% of the GDP, inline with the revised IMF target of 4.6%. In addition, this would leave a zero "primary balance" as compared to an estimated surplus of PkR72mn in FY09. If the GoP manages to maintain a primary surplus in the coming years, it will help reduce the overall debt servicing burden on government finances.


In FY10, we expect total fiscal outlays (federal) to increase by 25%YoY to reach PkR2.16tn as compared to an estimated 11.7% fiscal contraction in FY09. This would occur due to an expected hike in both Current & Development expenditures in FY10. .

Current Expenditures: We expect a rise in non-discretionary spending especially Defense & Security related and on servicing of domestic debt which is projected to eat away a whopping 76% of resources allocated for current expenditures. With NSS rates currently averaging 13.6%, while yields on T-bill and PIB's averaging 13.4% and 13.7% respectively, servicing the relatively expensive domestic debt taken post FY07 and repaying the market based IMF SBA loan will cause a short term spike in debt servicing burden, in our view.

We project debt servicing to rise to PkR853bn i.e. 52% of total current expenditures as compared to an average of 38% during FY04-FY07. Similarly, rising level of militancy in the country's north western province will obviously require greater resource allocation for military and other security apparatus. We, therefore, expect Defence and Public Order & Safety spending to rise by 20%YoY to reach PkR372bn in FY10. .

In addition, the GoP might be compelled to provide relief to government employees by increasing wages & pensions by around 20%, equivalent to the average rate of inflation in FY09. In contrast, we project only a marginal 10% increase in the level of spending on education & health whose weight in current expenditures is expected to remain marginal & stagnant at 1.6% in FY10. At the same time, we think that growth in current expenditures will still be limited because of an expected marked reduction in the overall subsidy burden. We anticipate funds allocated for subsidies to normalize to around PkR20bn in FY10 considering that major subsidies like that on fuel and phosphate fertilizers have been eliminated while that on power (electricity tariff differential) will be abolished by end-FY09.

Development Expenditures: We are of the view that the GoP might find it necessary to again jack-up the level of development spending after having curtailed it by around 59.2% in FY09. This should occur in light of the inadequate level of physical infrastructure, responsible for the numerous production bottlenecks and high overall cost of doing business in the economy.

Recent studies suggest that the country is likely to experience acute water shortage in the medium to long term due to the change in weather pattern and loss of forest cover. In our view, greater emphasis will be placed on water related infrastructure in next years' budget in order to buildup water storage capacity. This coupled with increased need for reconstruction/development programs in the country's north western regions would entail a sharp rise in total development expenditures to PkR514bn in FY10 as compared to PkR187bn in FY09, in our view.


The IMF has set a tax collection target of PkR1.516tn for FY10 which would logically entail either significant expansion of the tax base (possible inclusion of the Agri sector) or a hike in the tax burden on the already taxed segments (services & industrial) of the economy. Even then, we think that the slump in domestic economic activity will take time to reverse which will keep corporate profitability and hence direct taxes (40% of total taxes) subdued. The tax collection efforts might further be hampered by the ongoing contraction in imports (down 38.4% YoY in Mar'09) & aggregate demand which would in-turn restrict growth in Custom duties and Sales tax the two major contributors to indirect taxes. However, expected strong agricultural productivity growth and resultant improvement in rural income levels should partially offset the likely contraction in urban demand and hence limit erosion in indirect tax mobilization. In light of these factors, we think that total tax generation in FY10 will be around PkR1.29tn as compared to PkR1.136tn estimated in FY09. Out of this amount, direct taxes are projected to total PkR481.6bn (up 12%YoY) and indirect taxes PkR812bn (up 15%YoY). .

Direct Taxation: With industrial production facing steep contraction and services sector in marked slowdown, achieving IMF target of raising PkR639bn through direct taxation in FY10 will be difficult without broad based taxation reforms and efficiency gains. In addition, we think that the new political administration with deep agri links might find it politically inexpedient to tax agricultural incomes in the upcoming budget. Therefore, although agricultural sector growth and hence rural incomes ought to improve in FY10, its contribution towards direct taxes will remain minimal. Hence, we think that GoP reliance on Indirect taxes would remain strong in the near term.

Indirect Taxation: The GoP is likely to further increase taxes on consumption through bringing more items into the Sales & Excise tax base or by increasing the GST rate. Further increase in custom duties and tariffs on non-essential import items might also be key highlights of the upcoming budget. Although we think that this predilection for indirect taxation would worsen the "regressiveness" of the current taxation structure and at the same time prove inflationary, it should translate in a healthy 15% growth in indirect taxes in FY10.


The above base case levels of fiscal expenditures and resource mobilization would leave a total financing gap of around PkR684bn i.e. 4.5% of the GDP, marginally lower than the revised IMF target of 4.6% for FY10. Considering that bond flotation and major privatization of government enterprises might be imprudent under the existing set of domestic political/security conditions and prevailing flux in international capital markets, the resource gap would most likely be financed by external receipts. The international community has already pledged substantial aid & loans for Pakistan through the US Peace Act and FoDP platform; we project budgetary external financing to rise to around PkR328bn (IMF projection PkR140bn) as compared to average of PkR232bn during FY04-FY08. The remaining gap will easily be bridged by domestic bank borrowing which is projected to total PkR300bn, lower than our estimates of PkR356bn for bank borrowing in FY09. Lower bank borrowing requirement, along with monetary easing, should help ease pressures on market interest rates while at the same time checking the crowding out of the private sector credit seen in FY09.

Our Shadow Budget for FY10 leaves zero "primary balance" as compared to a primary surplus of PkR78bn in FY09. We are of the view that the primary account is kept balanced over the coming years it will help reduce the overall debt servicing burden on government finances. To conclude although we think that the next year's budget will have a populist tinge with greater focus on development spending and social support, overall fiscal outlays would on the whole be inline with the benchmarks set by the IMF. Hence, we are of the view that the country will continue on the path of fiscal consolidation in the next fiscal year and at the same time "gradually" initiate pro-growth/countercyclical policies.