Frontier Markets
Unlike in the past, Saudi Arabia is currently pursuing a counter-cyclical policy. This is the right policy and could lead to a re-rating of this bourse in the long run. In the short term however, rising interest rates, tight fiscal policy and lower oil prices will lead to growth deceleration and weigh on share prices.
Highlights The bull run in Vietnamese stocks is due for a pause as the weakness in overall EM markets spreads to this bourse. Household consumption will stay constrained as new COVID-19 cases remain high and fiscal and monetary stimulus remain absent. Social distancing measures and related supply disruptions have hobbled labor-intensive manufacturing and exports thereof. Vietnam is facing saturation or stagnation in two of its major exports: electronics and phones. The country needs to find a new high value-added export sector to which to transition to maintain large trade surpluses. Vietnam’s longer-term structural outlook remains bright. The country is set to gain further global export market share due to strong productivity gains and competitive unit labor costs. Absolute-return investors should book profits on their Vietnamese holdings for now and wait for a better entry point. Asset allocators, however, should continue to overweight this bourse in overall EM, emerging Asia or frontier market equity portfolios. Feature Vietnamese stocks have surged to new highs in absolute terms and have outperformed their frontier and emerging market peers since spring 2020 (Chart 1). Can the bull run continue into the new year? We advise caution. Vietnamese stocks may be in for a period of weakness in absolute terms. The reason is a negative outlook on EM markets: a drop in EM stock prices is typically followed by one in Vietnamese stock prices (Chart 2). Chart 2Weakness In EM Markets Typically Spreads To Vietnamese Stocks Too Chart 1The Bull Run In Vietnamese Stocks May Be Due For A Pause In addition, Vietnam’s exports, the mainstay of this market, are likely to face some headwinds in the months ahead. Absolute-return investors therefore would do well to book profits now and wait for a better entry point to this bourse later in the year. That said, the longer-term outlook of this economy remains bright, and that will help boost this market beyond any near-term jitters. Robust fundamentals should also ensure continued outperformance relative to overall EM stocks. We recommend that investors stay overweight Vietnam in EM and emerging Asian equity portfolios. Battered Consumption The surge in daily new cases since August last year forced Vietnam to implement stringent lockdowns and social distancing measures. A consequence of these measures was a free fall in Vietnam’s household consumption. Both retail sales and car sales plummeted to levels not seen since 2016 before recovering recently (Chart 3). This caused the economy to shrink by over 6% in real terms in the third quarter last year – the first-ever contraction in decades. Now, with the new, highly infectious Omicron variant spreading fast, the number of daily new cases and deaths remains stubbornly high – despite many of the lockdown measures still in place (Chart 4). It is therefore far from clear when normal economic activity will resume. Incidentally, 57% of Vietnamese people have been fully vaccinated so far. Chart 4Rising Omicron Cases May Hobble Economic Activity Again Chart 3The Surge In The Delta Variant Last Year Severely Hurt Vietnamese Household Consumption Notably, despite the weak economy, there has not been any meaningful policy stimulus in recent months. Fiscal policy has remained very tight. Government spending, excluding interest and principal payments, has contracted by 4.5%. The 2022 budget proposals envisage only a 2% rise in total nominal fiscal expenditure. The central bank, for its part, has also not announced any new easing measures in the recent past. Lacking fiscal and monetary support, domestic consumption and therefore overall growth will remain somewhat constrained going forward. Supply Disruptions While domestic consumption is a concern, a more investor-relevant issue in Vietnam is the pandemic’s negative impact on the country’s manufacturing/export sector. This is because, unlike household consumption, manufacturing activity and manufacturing exports have a strong bearing on the country’s stock prices. The reason is that developing market stocks in general are driven by global trade cycles. And since Vietnam’s total trade amounts to almost twice as much as the country’s GDP, the ebbs and flows in the former have an outsized impact on the domestic economy, and by extension, on the stock market (Chart 5). The surge in new cases since August created severe hindrances in the manufacturing/export sector supply chains and labor availability. In the clothing and textile industry, almost a third of the sector’s three million employees quit jobs, or stayed away from work with or without pay, as per Vietnam Textile & Apparel Association, an industry body.1The lack of labor coupled with bottlenecks in logistics have led to a sharp drop in Vietnam’s textile and garment exports (Chart 6, top panel). Chart 6Garment Exports Are Badly Hit, While Phone Exports Are Facing Stagnation Chart 5Vietnamese Stocks Are Highly Leveraged To Export Growth Due to hobbled production, manufacturing inventories have piled up (Chart 7). It is estimated that most of this large inventory is comprised of raw materials and intermediate goods. If so, that will discourage local raw material/intermediate goods production in the months to come. Chart 7The Pandemic Is Hampering Shipments While Inventories Are Piling Up In sum, it’s far from clear that a rapid revival in manufacturing production and exports is in the cards amid the ongoing Omicron surge. This will remain a headwind for Vietnamese stock prices. Exports Outlook Despite the setback in the textile sector, the country’s overall exports held up quite well last year. That’s because the slack was more than made up by the booming computer and electronics exports. This is thanks to the massive demand surge in those goods in past two years due to the global work-from-home phenomenon (Chart 6, top panel). However, going forward, odds are that global demand for these items will abate as saturation sets in. This will slow the growth rate in Vietnam’s computer and electronic exports. Incidentally, Vietnam’s single largest export items, phones and spare parts, are also showing signs of stagnation. In absolute dollar terms, they have been flattish since early 2018. Phone production volumes have remained at the same level as in 2015 (Chart 6, bottom panel). With mobile phone penetration in all major economies is already quite high, phone exports certainly cannot propel Vietnam’s exports as strongly as in the past decade. If this is the case, it can have a meaningful negative impact not only on Vietnam’s exports, but also on its trade balance, and by extension, its current account balance. The reason for this is that phones and spare parts have probably been the most value-added item among Vietnamese exports. The difference between the export revenues they earned and the import cost of the components has been much higher and has risen more sharply than in any other major export items (Chart 8, top and middle panels). This helped the country rack up rising trade surpluses. In the absence of net export revenues from phones and spare parts, Vietnam’s trade and current account balance would be deeply negative (Chart 8, bottom panel). Given that phones are no longer the sunrise sector worldwide, the country needs to find and move to some other high value-added sector to maintain its wide trade surplus. As of now, it’s not clear that this is happening. In the past two years, the number of newly approved manufacturing FDI projects have fallen to decade-low levels. The dollar value of approved manufacturing FDI projects has also fallen in tandem (Chart 9, top panel). In fact, overall FDI approvals have also fallen – suggesting actual FDI inflows might weaken in the months ahead (Chart 9, bottom panel). Chart 8Net Phone Exports Had Been Crucial To Vietnam's Large Trade Surpluses Chart 9FDI Inflows Into Vietnam Might Recede In The Coming Months Until Vietnam finds a new high value-added export sector to which to transition, its stagnating phone and electronics exports mean that overall export growth is set to take a breather. Finally, one external tailwind for Vietnam since 2018 has been the trade war between the US and China. Because the two largest economies put various tariff and non-tariff barriers on each other, it allowed Vietnam to double its share of imports to the US in just three years (Chart 10). Vietnamese exports also clearly benefit when the dong weakens vis-à-vis the Chinese yuan. The fact that the Chinese authorities have allowed the yuan to be one of the strongest currencies over the past year has helped Vietnamese exports. In the future, however, decelerating growth in China may prompt the PBOC to seek a weaker yuan. If so, that could be another headwind to Vietnamese exports (Chart 11). Chart 11The Tailwind From A Weak Dong Versus The Chinese Yuan May Diminish This Year, Hurting Exports Chart 10Vietnamese Exports Benefitted Immensely From The US-China Trade War In sum, Vietnamese exports could well see a period of weakness in the coming months. That is usually a harbinger of weaker Vietnamese stock prices in absolute terms (Chart 5, above). Structurally Sound Despite our near-term cautious outlook on Vietnamese stocks, we have a positive view on the country’s structural prospects. The country’s fundamentals remain robust and that will help propel this market beyond any near-term weakness: Vietnam has boosted capital spending in the past few years to reach an impressive 32% of GDP, among the highest in the developing world (Chart 12, top panel). This has helped raise the economy’s productive capacity. Consistently, Vietnam’s labor productivity gains have been superior to most developing countries (Chart 12, bottom panel). The country’s wage growth has been relatively lower than those of China and Bangladesh, its two main export competitors (Chart 13, top panel). Chart 12Vietnam's Capital Spending And Labor Productivity Remains Among The Highest In EM Chart 13Competitive Unit Labor Costs Are Helping Vietnam Rapidly Grab Global Market Share Stronger productivity gains coupled with relatively muted wage growth is helping keep Vietnamese unit labor costs lower than its competitors. This is boosting its competitiveness; and not only helping grab an ever higher global market share, but also doing so at a faster clip than even China and Bangladesh (Chart 13, bottom panel). The country is also well placed to take advantage of its competitive unit labor costs. It has entered into a number of free trade agreements (FTA) with many countries and regions, the latest of which is the RCEP agreement – comprising ASEAN, China, Japan, South Korea, Australia, and New Zealand – which kicked in this January. These FTAs have eliminated export import tariffs for hundreds of items. Vietnam is likely to be a major beneficiary of these treaties in the medium to long term, given its rising competitiveness. Given the already available infrastructure and labor and its competitive edge in manufacturing, Vietnam is also set to be the major recipient of the firms relocating away from China. This will further boost its longer-term prospects as exports will continue to generate solid income growth. Overall, real income per capita in Vietnam will continue rising at a rapid rate, outpacing that of most emerging economies. Investment Conclusions Chart 14Vietnamese Stock Valuations Are Not Attractive Now Since the country’s exports will likely decelerate in the coming months, its share prices will also likely correct. In addition, the ongoing sell-off in EM risk assets has further to run, as explained in our last report, EM: A Perfect Storm. This is a harbinger of weaker Vietnamese stock prices. What’s more, a sell-off in EM risk assets is often associated with a considerable decline in capital inflows into Vietnam – as was the case in 2015 and 2018. Those periods were negative for Vietnamese stocks as well. Finally, valuations are not attractive either. Trailing P/E and P/Book ratios of Vietnamese stocks are much higher (21 and 3.6, respectively) compared to those of EM (14 and 1.9) and frontier market (15.5 and 2.3) stocks (Chart 14). Putting it all together, absolute-return investors should book profits on their Vietnam holdings and wait for a better entry point. Asset allocators, however, should continue to maintain their overweight positions on Vietnamese stocks, in EM, emerging Asia or frontier market equity portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 Please refer to “Vietnam garment exports hit hard by labor shortage, disrupted supply chains, and swelled freight fares” on Textile Today Bangladesh.
Highlights Liquidity conditions in Bangladesh are easy and growth has revived. Exports are set to recover as well. Foreign reserve accumulation will continue, which will have positive implications for the economy and stock prices. Steadily rising capital expenditure has improved the economy’s productivity and competitiveness. Progress towards gender and income equality has also been impressive. Growth will stay strong and steady, which warrants higher equity multiples. Bangladeshi stocks also have low correlation with their EM and Emerging Asian counterparts, providing diversification benefits. Absolute return investors should buy this market on dips. Dedicated EM/Frontier market equity portfolios should consider overweighting Bangladeshi stocks. Feature A new business cycle appears to be unfolding in Bangladesh. Domestic demand has picked up. Exports are slated to rise as well. The country’s structural progress also continues to be impressive. Not surprisingly, stocks have gone up in tandem. Yet, high and rising oil prices may lead to a pause in the rally. Absolute-return investors with a time horizon of more than one year should therefore consider accumulating equities on dips. Dedicated equity investors should consider adding the very ‘low-correlation’ Bangladeshi equity market to an EM Asia/EM equity portfolio (Chart 1). External Tailwinds Bangladesh’s foreign reserves have surged to a new high. This has been a very positive development for both the economy and stock prices (Chart 2). Chart 1Bangladeshi Stocks Will Benefit From Liquidity Tailwinds Chart 2Foreign Reserves, M1 And Stock Prices Chart 3Both Current And Capital Account Balances Have Improved The country’s balance of payments (BoP) has improved substantially in the last couple of years. The improvement can be attributed to both current and capital accounts: The current account deficit has narrowed significantly since 2018. The improvement will likely persist as the outlook of its two main components are both promising: Remittances have surged to an all-time high of $25 billion over the past 12-months. In the coming year too, it will likely stay buoyant thanks to a 2% incentive scheme that the government introduced on inward remittances (Chart 3, top panel). The second major component, the trade deficit, will likely stabilize. This is because exports are set to pick up, in part due to rising orders from the EU, Bangladesh’s prime export destination (Chart 4). The recent surge in trade credit inflows also implies a significant rise in export revenues in the coming months (Chart 5). That said, high oil prices, if they remain as such, will lead to higher import bills. Crude and petroproducts make up about 10% of Bangladesh’s import costs and can be a headwind to the trade balance, and by extension, stock prices. Chart 6 shows that stock prices accelerate when oil prices are low, but struggle when oil prices rise. Chart 4Strong EU Orders Means Exports Are Set To Accelerate Further Chart 5A Surge In Trade Credit Also Implies Strong Export Numbers Ahead Capital account inflows have risen sharply too. The rise is due mainly to surging trade financing inflows (as mentioned above), and elevated government foreign borrowing (Chart 3, bottom panel). Going forward, trade financing inflows can remain at a high level if the country continues to obtain the same volume of export orders. The government’s foreign borrowing may also persist. Notably, this long-term financing is mostly used to import capital goods – something that the country needs for its investment and infrastructure projects (Chart 7). With Bangladesh’s ever-rising capital expenditure, such long-term capital inflows – either in the form of government borrowing, or FDI, or a combination of two – will likely continue. If so, this will not only help boost the country’s BoP in the short-term, but it will also be a long-term positive for Bangladesh since capital spending will help improve productivity. Chart 6Stocks Struggle Whenever Oil Prices Rise Too Much Chart 7Government's Foreign Borrowings Help Finance Infrastructure Projects Overall, odds are that the BoP will stay in healthy surplus, thus allowing the central bank continue to accumulate foreign exchange reserves. This has major ramifications for the domestic economy. Rising foreign reserves augment domestic money supply. Stronger money supply is bullish for the economy, and in turn, stock prices (Chart 2, above). Growth Has Revived Domestic demand has revived. Manufacturing has risen to well-above pre-pandemic levels. Robust economic activity is also vouched for by strong electricity generation (Chart 8). What’s more, the recovery will likely have legs as a new credit cycle could well be unfolding. For one, banks are flush with excess reserves – usually a precursor to rising credit going forward. This is because the Bangladeshi central bank uses excess reserves to achieve its monetary policy objectives1 (Chart 9). Chart 8Bangladesh's Domestic Growth Has Revived Well Beyond Pre-Pandemic Levels Chart 9A Deluge Of Excess Reserves Will Help Kickstart A New Credit Cycle Chart 10Banks' NPL Problems Have Abated Marginally Incidentally, the central bank is planning to engineer an acceleration in its domestic credit growth rate to 17.8% by June 2022, up from 10.3% in June 2021. It is also planning to augment the broad money growth to 15% from 13.6% in June 2021 as part of its 2021-22 policy objectives. That means the monetary policy setting will remain very accommodating in the foreseeable future, paving the way for a new credit cycle. Notably, the country’s inflation is under control, with both headline and core CPI hovering around 5 - 6% over the past few years. Wage growth has also been broadly in line with consumer inflation and shows no sign of accelerating. Contained wages and consumer price inflation will make the central bank’s plan to run easy policy more feasible. Meanwhile, the banks’ bad loan problems have abated somewhat. As per the latest data from the IMF, the banking system’s gross NPL ratio has fallen to 8.1%, and its net NPL ratio to 4.6% as of Q1 this year (Chart 10, top panel). The lingering NPLs are concentrated in a handful of state-owned banks whose role in the economy has steadily diminished and which now hold about 20% of the banking sector loans. Banks' capital adequacy ratios are also decent at 11.6% and 7.8% (for Tier I capital) respectively (Chart 10, bottom panel). Hence, banks will likely be more willing to expand their loan books going forward which should help propel economy. Chart 11Bangladesh Has Notched Up Impressive Growth Without Any Credit Gush Remarkably, over the past decade, Bangladesh has been able to notch up a robust growth rate of 7%+ without any credit gush in the economy. Domestic credit, at 48% of GDP, is at the same level as it was ten years ago (Chart 11). Hence, should a new credit cycle unfold, Bangladeshi’s growth rate will likely move up a notch higher than it has been in the recent past. The country’s fiscal stance is not going to be tight either. The parliament has passed a budget for the 2021-22 fiscal year (July – June) that envisages a nominal spending growth of 6.3%. Incidentally, government debt is rather low at 23% of GDP. Including the debt held by all the public corporations (concentrated in public financial corporations), gross public debt goes up to 56% of GDP - still a manageable figure. Real government borrowing costs are low as well. The 10-year nominal bond yield is at 6%; in real terms (deflated by non-food CPI), it is 0%. Thus, fiscal authorities have the wherewithal to ramp up borrowing and spending to stimulate the economy should there be a need. Robust Structural Backdrop Structurally, the Bangladeshi economy is remarkably resilient. The growth rate has not only been very steady but has also seen acceleration over the past quarter century. This is in sharp contrast to the boom-and-bust cycles experienced in most other developing nations (Chart 12). Even during the recent pandemic, Bangladesh has been one of the rare countries where growth has remained positive. Importantly, factors behind this stable growth are likely to persist: Bangladesh has done very well to ramp up its capital expenditure to a substantial 32% of GDP, one of the highest rates globally (Chart 13, top panel). This has helped the economy gain competitiveness over time – which is evident in the continued improvement in its net exports volume (Chart 13, bottom panel). Chart 12Bangladeshi Economy Has Been Devoid Of Boom-Bust Cycles Chart 13Strong And Rising Capex Has Led To Higher Competitiveness Strong capex has also been instrumental for the economy to grow at a very robust 6-7% rate for decades at a stretch and yet keep inflation under control. This indicates that productive capacity and labor productivity have been rising. Inflation is often a binding constraint to fast growth over a prolonged period of time. Bangladesh’s productivity growth rates have indeed risen to among the highest rates globally, the pandemic-hit last year being a deviation from the long-term trend (Chart 14). What’s more, given the sustained investment in productive capacity and the still low absolute level of labor productivity – compared to other East and South-east Asian economies – Bangladesh should continue to see robust productivity gains in the foreseeable future. Bangladesh specializes in a staple consumer product: textiles. Rising productivity has helped export volumes quintuple over the past two decades; handily beating both emerging markets and global exports volume growth. Incidentally, in common currency terms, the relative wage ratio between Bangladesh and China has been flat at a low level. This has helped Bangladesh remain competitive and continue to expand its global export market share (Chart 15). Chart 14Bangladesh's Productivity Growth Rate Is Among The Best Globally Chart 15Bangladesh Has Been Consistently Gaining Market Share In Global Trade The country’s demographic outlook is also positive. The working age population as a share of the total is projected to rise for another decade.2 Together, strong productivity growth and a rising labor force will ensure an enviable potential growth rate of around 7 - 8% over the next decade. Inclusive, Sustainable Growth Economic factors aside, strong and steady growth in Bangladesh also owes much of its achievements to social progress. Over the past few decades, the country has attained significant improvements in various human development areas: Bangladesh boasts of one of the highest female participation rates in its labor force in the Muslim world. At 36%, this is almost twice as high as the Middle East & North Africa (20%), Pakistan (22%), and neighboring India (21%) – as per the World Bank. In the fledgling textile industry in Bangladesh, over 75% of workers are women. The country pioneered microcredit, which by design mostly goes to women. The social fabric of the country is changing as women are now much more likely to make family / economic decisions. Spending on children’s food, health and education has gone up. Women’s fertility rates have gone down significantly. At the same time, infant / maternal mortality rates have witnessed one of the fastest declines seen anywhere globally. Chart 16Bangladesh’s Income Inequality Has Remained Low As Growth Has Been Inclusive Bangladesh’s income inequality – as measured by the Gini index – is one of the lowest in the world (Chart 16). What’s more, despite strong growth, inequality has not risen over the past 25 years. This is in stark contrast to many other advanced and developing countries. Such inclusive growth has rendered the society more equitable, making growth itself more sustainable. Bangladeshis have largely embraced their more liberal linguistic identity over their religious identity. For context, Bengali-speaking Bangladesh was born out of an extremely violent secession from the Urdu-speaking people of Pakistan in 1971 as the former realized that culturally their linguistic identity supersedes their religious identity.3 As such, the vast majority of Bangladeshis practice a moderate form of Islam. This factor has helped to encourage such social changes as the empowerment of women and the expansion of microcredit as religious / cultural opposition has been low. These major traits of this society, including those of gender and income equality, are likely to persist in the foreseeable future. Therefore, odds are that the strong growth will continue to remain inclusive and therefore sustainable. Investment Conclusions The Bangladeshi equity market exhibits a very low and often a negative correlation with both the EM and Emerging Asian markets. In particular, periods of global risk aversions, such as in 2014-15 and early 2020 saw the correlations turn negative. This increases market attractiveness to asset allocators as it will allow them to reap diversification benefits (Chart 17). That said, this bourse has risen significantly over the past year or so and has outperformed its EM counterparts (Chart 1 in page 1). Its valuations have also risen and are now on par with their EM peers (Chart 18). As such, there could well be a period of indigestion / consolidation – especially if our view of a stronger dollar and rising US bond yields transpires, and oil prices remain elevated over the next several months. Chart 17Bangladeshi Stocks' Correlation With EM Turns Negative During Bear Markets Chart 18Bangladeshi Stock Valuations Have Risen, But Are Not Excessive Putting it all together, we recommend that absolute return investors with a time horizon of over one year should adopt a strategy of ‘buying on dips’ for Bangladeshi stocks. Dedicated EM/frontier market equity portfolios should consider overweighting Bangladeshi stocks. Finally, regarding the currency, the Bangladeshi taka will likely remain more or less stable over the next year or so. The taka rarely depreciates unless the country’s BoP begins to deteriorate materially. As explained above, that is not in the cards. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 Bangladeshi central bank tries to control the ‘quantity’ of money/credit, rather than the ‘price (i.e., interest rate)’ to conduct its monetary policy. To explain, it controls the ‘reserve money’ growth and thereby impact the ‘broad money (M2)’ growth - to achieve its objectives on economic growth, inflation, and the exchange rate. 2 As per the United Nations’ World Population Prospects 2019. The same metric for Vietnam, Bangladesh’s main exports competitor, has peaked in 2015. 3 For a detailed account of the geopolitical outlook of Bangladesh and the larger South Asia, please see South Asia: A New Geopolitical Theatre from BCA’s Geopolitical Strategy team.
Highlights Kenyan financial markets will sell off considerably ahead of the presidential elections next August given the backdrop of very weak growth, a rising public debt-to-GDP ratio and growing odds of a shift away from orthodox macroeconomic policies. We do not think that the IMF-imposed fiscal austerity program will stabilize public debt dynamics. Kenya is currently experiencing an unprecedented political change from ethnic politics to class-based confrontation. Such a shift will raise the probability of populist policies following the elections. Besides, both main presidential candidates are advocating for the abandonment of fiscal and monetary austerity. This bodes ill for sovereign credit and the exchange rate. Feature Deflationary forces stemming from substantial fiscal austerity and potential political volatility ahead of the presidential elections next August will produce a major growth disappointment in Kenya in the coming 12 months. Dismal growth will depress share prices. Underwhelming nominal GDP growth and a rising public debt-to-GDP ratio warrants wider Kenyan sovereign credit spreads. The impact on the exchange rate is more complicated. In the short run, the currency could be supported by high real rates and tight fiscal policy. Yet, potential political volatility and associated capital flight amid large twin deficits will weigh on the exchange rate. In the long run, the only way for the nation to stabilize the public debt-to-GDP ratio is to boost nominal growth and bring down interest rates. This will herald currency depreciation. Unsustainable Public Debt Dynamics Chart 1Kenya: Negative Fiscal Thrust Ahead With guidance from the IMF, the government has adopted fiscal austerity that commenced in fiscal year (FY) 2020/21 and is expected to last into FY 2023/24. The primary fiscal thrust will be -1.8% of GDP and -1.6% of GDP for FY 2021/22 and FY 2022/23, respectively, according to IMF estimates (Chart 1). This constitutes an enormous fiscal drag on the Kenyan economy. This fiscal straitjacket has been imposed in response to dire state finances and worsening public debt dynamics. Specifically: Public debt has risen considerably over the past decade from 35% to close to 70% of GDP (Chart 2, top panel). Kenyan authorities have borrowed heavily, in both local and foreign currencies, to finance various development projects (Chart 2, bottom panel). Yet, the government has failed to generate adequate revenues to service its debt. Notably, tax and overall government revenues have been falling relative to GDP (Chart 3). Chart 2Kenya: Public Debt Has Doubled Over The Past Decade Chart 3Kenya: Lackluster Government Revenues More worryingly, interest expenditures on public debt consume 28% of revenues and 18% of government expenditures (Chart 4). Meanwhile, interest on foreign currency debt makes up 15% of total exports. All these ratios are high. Chart 4Kenya: Interest Payments On Public Debt Are High Lastly, debt restructuring among state-owned enterprises1 (SOEs) will further raise public debt. In short, Kenya’s public debt has increased significantly, forcing authorities to enact fiscal austerity measures to appease the country’s creditors. Fiscal Austerity Will Dampen Growth… We do not believe that the fiscal austerity program imposed by the IMF will help achieve fiscal sustainability. Both IMF and government projections for nominal growth, fiscal revenues and public debt are too optimistic given the weak state of the economy and tightening fiscal and monetary policies. Primary fiscal spending is expected to grow by only 1.6% in nominal terms in FY 2021/22. Meanwhile, nominal GDP and government revenue are projected to grow by 10% and 11%, respectively, in FY 2021/22. Consequently, the government expects to improve the primary budget balance from a deficit of 4.6% of GDP in 2021/22 to a primary surplus by FY 2023/24 (Chart 5). Specifically, nominal GDP and government revenues will underwhelm because: First, fiscal austerity amid a feeble economic recovery will materially depress nominal growth and government revenues/taxes. As a result, the nation will not meet its budget balance targets and the public debt-to-GDP ratio will continue to rise. Core inflation measures are at the lower end of the central bank target range of 2.5% to 7.5% (Chart 6). Lower inflation implies that nominal GDP growth will fall short of government projections for next year. Besides, government expectations of improved tax collection in such a short time span are unrealistic. Chart 5Kenya: Dire State Finances Chart 6Kenya: High Headline CPI Will Prevent The Central Bank From Cutting Rates Chart 7Kenya: The Banking System Is In A Dire State Second, interest rates are very high in real terms (adjusted for core CPI) for the current state of the economy. Notably, diverging headline (high due to sharply increased food and energy prices) and core CPI (very low due to very subdued domestic demand) makes it unlikely that the central bank will chose to cut interest rates anytime soon (Chart 6). High government bond yields, large non-performing loans and a weak economy will incentivize commercial banks to buy government bonds rather than lend to the private sector (Chart 7). This will hinder household and business spending. Third, the government has reinstated higher personal, corporate and VAT tax rates to pre-pandemic levels. These de-facto tax increases will hurt both consumer and business incomes and confidence. With tight fiscal policy and high lending rates in real terms, domestic demand will fail to recover. The uncertainty over next year’s election outcomes will entice domestic firms to delay their capital expenditure plans. This also bodes ill for an economic recovery. Fourth, delays in vaccine procurement will allow COVID-19 variants to continue spreading across the country. In addition, vaccination rates in Kenya will remain depressed due to vaccine hesitancy and the significant mistrust of the government. Bottom Line: A substantial growth recovery will fail to materialize under fiscal austerity, high real lending rates and election uncertainty. Nominal GDP growth will underwhelm in the next 12 months. …And Fail To Stabilize Public Debt Dynamics The two pre-requisites to cap the rise in the public debt to GDP ratio – (1) running continuous primary fiscal surpluses and/or (2) having nominal growth above government borrowing costs – will not be met in Kenya for now. First, projected small primary surpluses will not materialize as nominal GDP and government revenue growth underwhelm. Second, as the central bank will be forced to keep high interest rates, nominal GDP growth will remain below government borrowing costs. Chart 8Kenya: Large Current Account Deficit The central bank will be reluctant to reduce interest rates meaningfully despite very low core inflation and weak real GDP growth. The basis is that monetary authorities will fear that the Fed’s tapering and potential political volatility in Kenya could lead to considerable currency depreciation. Notably, dwindling FDI amid political uncertainty will force the central bank to maintain high interest rates to attract foreign portfolio capital. The latter are needed to finance a still sizable current account deficit (Chart 8). Overall, local interest rates will remain higher than is warranted by fundamentals. As a result, the public debt-to-GDP ratio will continue to rise due to elevated interest rates and disappointing growth. Bottom Line: Very low nominal GDP growth amid high government borrowing costs as well as the need to take over SOE debt will result in a wide fiscal deficit and a rising debt-to-GDP ratio. Political Volatility And A (Post-Election) Shift To Populism Chart 9Elections = Currency Depreciation In the next 12 months, the current government is unlikely to abandon fiscal austerity. The fragmentation within the Jubilee coalition government will not produce a shift away from fiscal austerity. Besides, President Kenyatta has been a vocal supporter of orthodox economic policy in recent years. Yet, a key contender for next year’s presidential elections, deputy President William Ruto, is a fierce critic of fiscal austerity (and of the IMF). He has already been running a populist campaign calling for a more equitable society and a redistribution of income and capital in favor of the poor. His campaign slogan “Hustlers nation vs. Dynasties”2 is already gathering support amongst lower income young voters whilst creating socio-political tensions within the country. Similarly, opposition leader Raila Odinga has been a long-time critic of the IMF’s fiscal austerity. His recent comments also call for more fiscal spending. In brief, neither presidential candidate is likely to follow through with fiscal austerity upon being elected. Historically, past Kenyan election outcomes have been determined by “tribal power brokers” who garnered inter-ethnic alliances. This election cycle, however, will be dominated not by ethnic and tribal politics but rather by social and class-based hostilities possibly leading to some violence. This unprecedented shift in Kenyan politics from ethnic to class-based confrontation will raise the probability of populist policies following the elections next August. This will likely cause capital flight from the country’s elites who stand to lose from the more redistributive “neo-Marxist” ideas proposed by William Ruto. Remarkably, Kenya has been mired in violence, political instability, and large gyrations in domestic financial markets both before and after past elections (Chart 9). Investment Conclusions Chart 10Kenyan Sovereign Spreads Will Widen Sovereign credit: Avoid/underweight (Chart 10). We recommend investors go long Egyptian / short Kenyan sovereign credit. The report on Egypt can be found here. Stocks: Avoid/Underweight within an EM equity portfolio. Currency: The currency will depreciate versus the US dollar in the next 12 months. Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes 1 These include, Kenyan Airlines, Kenyan Airport Authority, Kenyan Railways Corporation, Kenyan Power and Lighting Company, Kenyan Electricity Generating Company, Kenyan Port Authority and three of the largest universities. 2 “Hustlers” relates to young, less economically fortunate citizens, while “Dynasties” designates the wealthy families that have ruled the country since independence in the 1960s. Both President Kenyatta and opposition leader Raila Odinga are said to come from the “Dynasties”, whereas William Ruto comes from the “Hustlers” group. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Authorities will be reluctant to devalue the currency this year to avoid a pass-through of higher global food prices into domestic food prices. Yet, chronically underwhelming economic growth will ultimately force the government to abandon tight fiscal and monetary policies and adopt a pro-growth agenda. A part of such a policy shift will be currency devaluation. Egypt’s productivity gains will be limited, which will keep potential GDP growth tame. A major buying opportunity in Egyptian local currency bonds, sovereign credit and equities will follow on the heels of currency devaluation. Feature The Egyptian government is facing a dilemma between tolerating very weak economic growth and a rising public debt burden on the one hand and currency devaluation on the other hand. In the near-term, they will continue pursuing tight fiscal and monetary policies to avoid currency devaluation. However, over a long-run time horizon, the dismal productivity outlook leaves them with no option except to ease fiscal policy and reduce interest rates substantially to boost (nominal) growth. The upshot will be significant depreciation pressure on the exchange rate. No Appetite To Devalue … Yet Chart 1Rising Food Prices Is A Major Constraint To Currency Devaluation Over the near-term, Egyptian authorities will not devalue the currency because of the following: Rising food prices carry both economic and socio-political risks. Egypt imports 62% of its wheat and 60% of its corn consumption. Global food prices have risen sharply in the past 12 months. Devaluing the pound would exert pain on household budgets by raising the price of key imported grains in local currency terms (Chart 1). Higher food prices can reduce popular support for the government and heighten socio-political instability. Provided that food accounts for 35% of the consumer basket, rising food prices will curtail disposable income left after food expenditures. In turn, that will depress non-food household spending with negative implications for the entire economy. In brief, macro economic policy choices are presently constrained by high global food prices and the country’s large dependence of food imports. Currency devaluation is currently not a palatable political option. Structurally, Egypt’s domestic agricultural production is unable to meet its domestic consumption needs. Food insecurity has socio-political ramifications and also affects macro policy choices available to and made by authorities (for a more detailed discussion on food insecurity, please refer to Box 1). Box 1 Food Insecurity In the coming years, Egypt will continue to encounter severe challenges in food production and, hence, securing sufficient supplies of food for its rising population. Over the past decade, only 5% of overall investments went into agriculture while private investments into agriculture fell. This has resulted in stagnant agriculture productivity. Chart 2 illustrates that output per area harvested of wheat, corn and rice has been flat over the past decade. Of greater concern is the fact that wheat and corn production per capita have been falling while their consumption per capita has been rising (Chart 3). Faced with a projected population increase of 30 million by 2030 (from 100 million to 130 million), Egypt will be forced to spend more on food imports. Thus, these dynamics will expose Egypt even further to global food price fluctuations. In addition, Egypt faces a severe risk of fresh water shortages due to the Grand Ethiopian Renaissance Dam (GERD) construction on the Nile by Ethiopia. Critically, Egypt relies almost entirely on this source of water from the Nile for agriculture. Any major resolution appears unlikely to be reached between Egypt and Ethiopia. In particular, Ethiopia views the dam as part of its own national economic interests in the region. Above all, Ethiopia will not be materially pressured by the US or Europe to back down from its own national economic interest surronding the dam, as has been argued by BCA Research’s Geopolitical Strategy Service. Abroad, President Biden is focused on restoring relations with Iran and countering Chinese and Russian regional ambitions, while not showing major interest in the Horn of Africa. The Europeans, for their part, will not react too punitively towards Ethiopia, not wishing to destabilize Ehtiopia’s stability for now. Bottom Line: There are risks that Egypt’s food production per capita could decline due to shortages of fresh water in the years ahead. In such a scenario, the nation’s food insecurity will rise and will have ravaging effects on Egypt’s balance of payments and the economy as well as might also lead to socio-political distress. Chart 2Egypt: Stagnant Crop Productivity Chart 3A Large Gap Between Food Production And Consumption Chart 4Egypt: A Large Portion Of Foreign Debt Obligations Is Owed To Bilateral Creditors At $14.5 billion for the next six months, foreign debt obligations are manageable (Chart 4). FDOs measure the sum of maturing short-term claims, interest payments and amortization over the next 6 months. Two thirds of FDOs are composed of short-term banking claims that can be extended/rolled over. Meanwhile, amortization and interest payments make up about $5 billion of the FDOs due over the next six months. Critically, three-quarters of these payments are owed to bi-and multi-lateral creditors. Egypt’s bi-lateral partners include Gulf states as well as the IMF and the World Bank. All of them have an interest in the country’s stability and are likely to roll over Egypt’s debt. Even though the central bank’s net foreign currency reserves are only $14 billion, its gross reserves are $39 billion (Chart 5). Additionally, if needed authorities may request additional financing from their bi-and multi-lateral creditors to preclude a major currency depreciation in the coming months. The current account deficit will not widen in the coming months (Chart 6, top panel). Exports will benefit from high natural gas and oil prices (Chart 6, bottom panel). Energy represents 32% of the nation’s exports. Chart 5Egypt: FX Reserves Are Above 2016 Devaluation Levels Chart 6Egypt: Current Account Will Improve With Rising Nat Gas Prices... Besides, tourism revenues will improve later this year as European travellers, who represent two-thirds of tourist entries, resume vacationing amid a broadening rollout of vaccines. Further, remittances have remained resilient in the face of the pandemic (Chart 7, top panel). In the meantime, export revenues from transportation – primarily, from the Suez Canal – will be bolstered by booming global trade (Chart 7, bottom panel). In turn, tame fiscal spending and high real lending rates will keep a lid on domestic demand and, thereby, imports (Chart 8). Chart 7...And Rising Remittances And Transport Revenues Chart 8Egypt: High Real Interest Rates Are Weighing On Growth Chart 9Egypt: Real Bond Yields Are High Lastly, multi-decade low inflation, fiscal and monetary prudence, and high real bond yields will preclude large foreign outflows from local currency government bonds (Chart 9). This will help the government to avoid currency devaluation. Remarkably, the overwhelming majority of foreign portfolio inflows have been into domestic bonds, not equities. Therefore, as long as investors in local currency bonds do not flee, the authorities will manage to avoid devaluation. Besides, Egypt offers one of the highest real bond yields in EM, and as such offers value to investors in an environment of low global yields (Chart 9). Bottom Line: Authorities will be reluctant to devalue the currency this year to avoid a pass-through of higher global food prices into domestic food prices. They will do everything they can to defend the exchange rate in the coming months, including requesting more US dollar financing from bi-and multi-lateral creditors and possibly hiking domestic interest rates. An Unsustainable Macro Policy Mix Chart 10Egypt: Nominal GDP Growth Needs To Be Above Borrowing Costs Beyond the next six months or so, authorities will be compelled to choose between tolerating very weak economic growth and the rising public debt burden on the one hand and currency devaluation on the other hand. The rationale is as follows: Egypt has pursued very high interest rate policy to attract portfolio capital and preclude exchange rate depreciation. Interest rates in real terms have been extremely high (Chart 9 above). This has depressed economic activity and inflation. In fact, nominal GDP growth has fallen well below nominal government bond yields, lethal dynamics for public debt sustainability (Chart 10). We elaborated on Egypt’s public debt sustainability in our report from June 10th, 2020 and concluded that its public debt dynamics are on a dangerous trajectory due to elevated interest rates. Egypt needs to bring down local interest rates substantially and rapidly. In so doing, the central bank will lose control of the exchange rate. This analysis remains valid today. With interest payments on public debt consuming 50% of government revenues, 35% of government expenditures and 10.5% of GDP (Chart 11), high domestic interest rates are unsustainable in the long run. Given that local currency government debt makes up 80% of total public debt, lower domestic interest rates are critical to reduce interest payments on government debt and stabilize the public debt-to-GDP ratio which at the end of 2019 stood at 100% of GDP – the latest for which data is available. Tight fiscal policy has been, and will continue to be, used to cap the rise in public debt. The government is expected to run a primary fiscal surplus equivalent to 1.5% of GDP for the 2021/22 fiscal year (Chart 12). Chart 11Egypt: Interest Payments On Public Debt Are Enormous... Chart 12...Leaving Little For Fiscal Spending Yet, depressed government non-interest spending is capping nominal income growth and contributes to lower GDP growth. Overall, tight monetary and fiscal policies are not sustainable in the long run as they will continue to depress income growth, ultimately resulting in socio-political discontent. Given that the productivity outlook remains dismal (please refer to the section below), the only option to boost (nominal) growth is to ease fiscal policy and reduce interest rates substantially. The upshot will be significant depreciation pressure on the exchange rate. Fiscal and monetary easing along with currency devaluation will boost nominal GDP growth, pushing it above borrowing costs. In time, the public debt-to-GDP ratio will stabilize due to a faster rising denominator. This will remove the constraint on fiscal policy, allowing the government to abandon fiscal austerity and meaningfully boost public sector wages, various subsidies and social benefits (Chart 13). This will also allow, authorities to counter rising food prices with greater outlays to support lower-income households. Importantly, the split between local and foreign currency denominated public debt is 80% and 20%. The majority of local currency public debt is held by domestic institutions and local banks (Table 1). Foreigners own only 15% of government local currency bonds. Thus, local institutions will blunt the impact of foreign selling amid fears of currency devaluation. Chart 13Egypt: Fiscal Spending Has Been Downshifting For Several Years Table 1Egypt: Composition Of Domestic Bond Holdings Meanwhile, loans from international and bilateral organizations account for three-quarters of foreign currency public debt. These can be restructured, and debt servicing can be delayed, providing fiscal authorities with some breathing room. Bottom Line: Chronically underwhelming economic growth will ultimately force the government to abandon tight fiscal and monetary policies and adopt a pro-growth agenda. A part of such a policy shift will be currency devaluation. No Structural Growth Improvement Chart 14Egypt: Structural Deficiencies The only way an economy can grow faster in an environemnt characterized by tight fiscal and monetary policies and no currency devaluation is via higher productivity growth. Odds of higher productivity growth in Egypt are low. The nation has not implemented the structural reforms necessary to improve productivity growth. Egypt’s structural vulnerabilities, namely depressed investment, an uncompetitive manufacturing sector and a lack of skilled labor, will all hinder productivity gains (Chart 14). Privatization plans for most SoEs have been canceled or delayed. Only one major state asset has been sold to private entities since 2015. Nevertheless, some recently enacted reforms will incentivize foreign companies to increase investment in some key strategic sectors, particularly in the oil & gas sector. For instance, all foreign firms which are now able to own 100% of their investments in Egypt, have the ability to repatriate all of their capital and profits and have been offerred guarantees against nationalisation and price controls on goods. Bottom Line: Egypt’s productivity gains will be limited, which will keep potential GDP growth tame. As a result, the economy can only rely on the reflationary push from fiscal and monetary policies and currency devaluation to achive higher (nominal) growth. Investment Conclusions The Egyptian pound’s valuations are presently neutral (Chart 15). Authorities are unlikely to devalue the exchange rate in the coming months. This creates a window of opportunity to collect the carry by being long currency bonds without hedging currency risk. That said, Egypt’s domestic bond yields could rise along with US bond yields (Chart 16, top panel). Chart 15Egypt: Currency Is Fairly Valued Chart 16Egypt: High Carry But Yields Could Rise Alongside US Yields Nevertheless, in the long run, a major currency devaluation is likely as continued fiscal and monetary austerity, a depressed economy and rising public debt are not viable options for the government. Substantial fiscal and monetary easing will be required to reflate the economy. The upshot of this will be a considerable currency devaluation. Chart 17Egypt: Wait For Reflationary Policies To Upgrade Equities Concerning US dollar bonds, dedicated EM credit portfolios should remain neutral on Egypt. In the near term, spreads could widen as public debt stress builds up amid very weak nominal GDP growth. In the long term, currency devaluation will be a trigger to go long/overweight this sovereign credit. Finally, equity investors should continue avoiding this stock market until authorities adopt reflationary policies and devalue the exchange rate (Chart 17). Fiscal easing and lower interest rates will herald higher nominal growth and will be conducive to higher share prices. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com
Highlights Massive fiscal deficits and high borrowing costs have led the government into a debt trap: interest payments alone cost the exchequer nearly half its revenues. Pursuing a tight fiscal and monetary policy now reduces the country’s chances of extricating itself out of a debt trap. Foreign capital inflows have dried up, while the current account is set to deteriorate. Another balance of payment crisis looks increasingly likely. Foreign investors should stay away from Pakistani assets. Feature Pakistani stocks have massively underperformed their Emerging Markets counterparts over the past several years (Chart 1). They have become very cheap too. Is it the right time for investors to get in there? Or, is it a value trap? Our analysis suggests that it’s the latter. The government has fallen into a debt trap. It will likely take a long time and significant currency devaluation before the country gets its macro affairs back in order. Investors, therefore, should stay away from Pakistani assets. The Debt Trap Pakistan’s fiscal deficit, at 9% of GDP, is one of the highest among emerging economies. Notably, it’s not the pandemic-time expenditure that caused it to swell. Deficits had already ballooned to 10% of GDP by mid-2019 (Chart 2). Chart 1Pakistani Stocks' Massive Underperformance Reflects A Dire Fiscal Situation Chart 2Years Of Massive Fiscal Deficits Have Led The Government To A Debt Trap... Chart 3...As Interest Payments Alone Cost The Exchequer Half The Fiscal Revenue... Rampant fiscal deficits over the years have caused the country’s government debt to soar. At 87% of GDP (Chart 2, bottom panel), the federal debt has already become untenable because borrowing costs are very high. Worse, it is set to rise further in the coming years: The interest payments on public debt alone cost the country 45% of its total fiscal revenues every year. If defense spending is added, that figure reaches to two-thirds of fiscal revenues (Chart 3). This is clearly unsustainable as the government is left with little resources for developmental expenditure. The latter’s share in total expenditure has shrunk to a measly 12% (Chart 4). The meager developmental spending in productive capacity and infrastructure - both hard and soft - stymies an economy’s sustainable growth potential. Pakistan’s private sector capital spending, at just 10% of GDP, is also abnormally low. The underinvestment results in lower growth – which in turn, jeopardizes future tax revenues. That compels the government to borrow even more, and thereby incur even higher interest expenses – completing a vicious cycle. This is indeed what has happened: tax revenue growth has been cascading down over the past decade. Incremental revenues in the recent past have been clearly inadequate to cover the government’s debt servicing because borrowing costs have been high (Chart 5, top panel). The result is additional borrowing to pay interest on the existing debt. Chart 4...Leaving Little For Capital Spending, Which Fuels Inflationary Pressures Chart 5When Revenue Growth Can't Pay For Borrowing Cost, The Currency Sells-Off Rising current fiscal expenditure relative to developmental expenditure creates another problem: inflation. The reason is, higher current expenditure fuels demand for goods and services, while lower developmental/capital expenditure stifles their supply in the long run. Pakistan’s depleted capital stock has made the situation worse. Every time current expenditure surges relative to developmental expenditure, core inflation rises. The middle panel of Chart 4 shows that after a short break due to the pandemic, core inflation is set to rise again. Incidentally, it is the producer price inflation that leads the country’s overall inflation dynamics. This is because, being an underinvested economy, the supply side/producers have pricing power. Any rise in costs therefore can be easily passed on to the consumers. The bottom panel of Chart 4 shows that PPI inflation leads core consumer price inflation at every turn. This also means that core CPI will follow PPI higher in the months to come. To sum it up, Pakistan is heading towards a stagflation quagmire: not only is the country stuck in low growth, but also its core inflation will rise. The government’s borrowing costs (bond yields) are highly sensitive to inflation, especially to producer price inflation. The latter has accelerated and is approaching 10%; bond yields have begun to rise in tandem (Chart 6). This will cause the gap between the government’s revenue growth rate and the borrowing costs to become more adverse. Chart 6Government's Borrowing Cost Will Rise More As Inflation Is Rising This widening gap has investment implications. During stressful times when fiscal revenue growth rate falls significantly below borrowing costs, the currency typically takes the hit (Chart 5, bottom panel) The reason for that is, when this happens, investors become skittish about the sustainability of the country’s fiscal health and head for the exit. As capital leaves, the nation’s balance of payments dwindles – weighing on the exchange rate. Pakistan’s perennial primary fiscal balance deficits also tell a similar story, but from a different angle. Chart 7shows that even if one excludes interest payments, the country’s fiscal revenues always falls short of non-interest expenditures. The upshot is more borrowing to be able to pay for the non-interest spending. In brief, Pakistan is being compelled to borrow more not only to repay old obligations, but also to pay a rising amount on the interest on old loans. As such, the country’s fiscal position is on an unsustainable path. What’s important from an investor’s point of view is that fiscal dynamics have a major impact on the currency, and the present level of high deficits warrants a much weaker currency (Chart 8). Chart 7Fiscal Revenues Always Fell Short Of Even Non-Interest Expenditure Chart 8High Fiscal Deficits Usually Lead To A Weaker Currency The Policy Headwind The question then is, can the country grow its way out of this debt trap? The answer is, it’s doubtful. One reason it’s doubtful has to do with the restrictive policies Pakistan is pursuing as part of the IMF bailout terms.1 The authorities are raising taxes; they are also curtailing government spending. The immediate incentive for doing so is to raise fiscal revenues enough to plug the primary deficits. The IMF also favors raising interest rates. The rationale for that is both consumer and producer price inflation rates are approaching 10% and rising, while policy rate is only at 7%. Yet, it’s far from clear how pursuing tighter fiscal and monetary policies will be able to revive an economy skirting with recession. The IMF itself expects the country to grow at only 1.5% for the year ending June 2021. Chart 9Higher Interest Rates Are Bad News For Both Credit Growth And GDP Interest rates are a major driver of growth in Pakistan. This is because the loan demand in the country is highly sensitive to borrowing costs. As the top panel of Chart 9 shows, periods of rate cuts (shown inverted in the chart) materially boosted bank credit. Similarly, the periods of rising rates lead to decelerating credit. Bank credit, in turn, has a strong impact on economic growth. Periods of accelerating credit coincided with accelerating GDP, and vice-versa (Chart 9, middle panel). In effect therefore, it’s the interest rates that cause the ebbs and flows in this economy (Chart 9, bottom panel). Hence, if policy rates are raised materially going forward, that will be a formidable headwind for the economy. Fiscal spending, on its part, is the prime driver of the country’s money supply. This is because at around 24% of GDP every year, fiscal expenditures far outweigh the annual incremental bank credit in Pakistan. When fiscal deficits are financed by commercial banks and the central bank, money expands. As such a reduction in fiscal deficit will decelerate money supply. Indeed, once the effect of pandemic-time de facto QE that led to a surge in money supply wears off, there will be a meaningful slowdown in money growth – as fiscal expenditure has already decelerated significantly (Chart 10). A slowing money supply is indicative of a slowing economy. The only way Pakistan could escape the debt trap is via a strong and sustained economic (and fiscal revenue) recovery. But the authorities are adopting policies that will do the exact opposite: curtailed government spending and slower money/credit will hinder growth – at least in the near term. Meanwhile, the state of the economy remains fragile. Production levels of steel and automobiles are far below the pre-pandemic peak (Chart 11). The same is true for the overall manufacturing sector. Chart 10Curtailing Of Fiscal Spending Will Lead To Slower Money Growth Chart 11The Economy Remains Fragile, With Manufacturing Far Below Pre-Pandemic Levels Tighter fiscal and monetary policies to gratify the IMF program requirements at this juncture are going to short-circuit the recovery. Subdued growth, in turn, entails lower tax revenues. That means, primary balance will remain in substantial deficit – leading to even higher debt-to-GDP ratio. In sum, it will be very difficult for the government to grow its way out of the debt trap by pursuing tight macro policies. The External Mirage The next question then is, can external financial aids and loans help Pakistan to wiggle out of the debt trap? Again, the answer is, unlikely. Pakistan’s balance of payment (BoP) appears to have improved over the past year. But a closer scrutiny reveals that this improvement is fleeting: Part of the progress in BoP stems from the current account. Overseas workers’ remittances surged by 30% from a year ago in dollar terms. Trade deficit also improved as imports sank due to COVID-19 lockdowns. Neither of the above will persist. Remittance growth will come back to more realistic levels since most of the reasons for the surge were one-off in nature (See Box 1). As the economy reopens, imports will rise closer to pre-pandemic levels, further widening the trade deficit in the process. BOX 1 The Surge In Remittance Will Not Persist Pakistan government data shows that 47% more Pakistanis went overseas for employment in 2019 than in 2018. This must have a major, but one-off effect on remittances’ annual growth in 2020. The World Bank attributes the 2020 increase to the ‘Hajj effect’: a sharp reduction in Hajj visas by Saudi Arabia allowed Pakistani migrants remitting home the money saved for the pilgrimage. The sharp rupee depreciation in 2018-19 also encouraged migrant workers to send more money home in 2020. Finally, the Pakistani government gave tax incentives to boost remittances by cutting withholding tax on bank transfers in July 2020. This might have encouraged both genuine remittances as well as to disguise some exports revenues as remittances to take tax benefits. Notably, the rupee is once again becoming a headwind for trade. The reason is accelerating inflation – which is making real exchange rates more expensive. An expensive rupee makes the country’s businesses less competitive and hurts trade balance. In fact, trade balance has already begun to deteriorate following the appreciating real effective exchange rate. All this means the days of current account surplus are over (Chart 12). In terms of the financial account, the recent deterioration is more emblematic of the country’s core problems. A look at the components of the financial account would reveal that net FDI inflows have long been meagre at about 1% of GDP, despite Chinese investments in several Belt and Road Initiatives in Pakistan. Portfolio inflows have been negative (Charts 13). The only reason the financial account had surged in the recent past was due to sovereign borrowings by the federal government and the central bank (Chart 13, bottom panel). Those inflows from some benefactor countries (i.e., Saudi Arabia, the UAE, China) have since dried up. In fact, in a turn of events, Saudi Arabia has called back the $3 billion soft loan it had extended to Pakistan in 2018. The kingdom has also withdrawn a $3.2 billion oil financing facility.2 Chart 12Trade Deficit Is Widening Again, And Current Account Will Be Back In Deficits Chart 13Capital Inflows Have Receded Materially As Loans From Benefactor Countries Dried Up On its part, the IMF was unhappy with the progress on bailout conditions and had temporarily suspended the program last year – before releasing the latest tranche of $0.5 billion last week. In short, none of the financial account components seem promising enough to finance the impending current account deficits. That will push down Pakistan’s BoP to negative territory. A negative BoP means further depletion in Pakistan’s foreign reserves or currency depreciation or a combination of both. The country’s reserves (excluding gold) are already low at $9.2 billion – a mere two and a half months’ worth of imports. More crucially, the government’s annual foreign debt service obligations (amortization plus interest) alone can wipe out the entire reserve. In 2019 (latest data available), those obligations totaled $8 billion (Chart 14). Hence, odds are that Pakistan will face another balance of payment stress in the not too distant future. A relapse in BoP will be very bearish for the rupee (Chart 15). This warrants that foreign investors stay away from Pakistani assets for the moment. Chart 14Foreign Reserves Are Barely Enough For A Year's Foreign Debt Service Obligations Chart 15A Relapse In BoP Will Be Very Bearish For The Rupee The End Game And Investment Conclusions The least painful and the most plausible solution for Pakistan’s macroeconomic problems is a sizable currency devaluation to boost nominal GDP and grow out of its public debt trap. This will help the country gain external competitiveness. That time might then be useful to initiate meaningful structural reforms and begin building up the country’s infrastructure and productive capacity. Moreover, once a credible devaluation is done, FDI and other types of foreign investments are more likely to come in – capital that Pakistan desperately needs. Notably, of the $228 billion total government debt of Pakistan, about a third ($75 billion) is external debt. Most of the external debt is either from multi-lateral, bi-lateral or Paris Club lenders (about $60 billion) – which are typically soft loans (i.e., very extended repayment period, and lower rates). Hence, while a currency devaluation will surely raise the overall debt burden, the immediate amortization and interest payment pressures will not be that severe. They can also be renegotiated at the sovereign levels. If Pakistan opts instead to continue to pursue tight monetary and fiscal policies, the rebalancing of the economy will happen via real economic variables i.e., weaker growth, retrenchment of employment and lower income and spending. That will be a much more painful process. The irony is that even in that case, facing lower growth, capital will tend to leave the country and therefore currency will sell off anyway. What all this means for foreign investors is that they should wait for Pakistan’s macro adjustments to run their course before venturing in. Equity The country’s equity markets are dominated by bank stocks (67% of market cap in MSCI Pakistan index). As explained before, tighter policies will choke bank lending. And subdued growth will push up NPLs of Pakistani banks. Both are bearish for bank stocks. As such we are closing our pair trade of long Pakistan/short EM initiated on December 5, 2019, which has incurred a 12% loss as per Datastream indexes, and 44% as per MSCI indexes. For long-term asset allocators, however, we recommend a neutral weighting to Pakistan in an EM equity portfolio. The reason is, after the huge underperformance, much of the gloomy outlook is now priced in. The relative valuations are already at a hefty discount of 75% (trailing P/E) and 65% (price/book value) respectively, against their EM counterparts. Fixed Income And Currency Fixed income investors should stay away. Local government bond yields are set to rise further. All kinds of inflation measures – CPI, PPI and WPI – are accelerating; and government’s borrowing costs will rise with them. Rising US treasury yields will not help either. The rupee is highly vulnerable too. Notably, last year, in a de facto QE, the central bank had purchased a massive amount of government bonds. Its holdings of government securities are now five times as high as its foreign reserve holdings. Yet, that could not prevent bond yields from rising since April 2020 - when PPI bottomed. While the central bank will surely engage in more rounds of bond buying this year, that is unlikely to keep bond yields down. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 In July 2019, IMF approved a US$ 6 billion, 39-month, Extended Fund Facility for Pakistan. This was the country’s 23rd IMF bail-out since the country’s membership in 1950. 2 After Pakistan tried to form an alternative coalition of Muslim countries along with Malaysia and Turkey, the Saudi-Pakistan bilateral relations soured. The kingdom initially withdrew the deferred payment arrangements of $3.2 billion for oil purchases, and then last year asked Pakistan to repay the $3 billion soft loan. Pakistan had to take commercial loans from China to repay Saudi Arabia. Geopolitical tensions with the UAE also rose, following Pakistan’s alignment with Turkey. It has prompted the Emiratis to stop issuing new work visas to Pakistani migrants since last November.
In the May 7, 2020 report, we argued that structurally low oil prices could, eventually necessitate a devaluation of the Saudi riyal. Our assumption for average oil prices was and remains $40 in 2020, $40 in 2021 and $35 in 2022. As a long-term bet, we continue to recommend selling Saudi Arabian riyals in the forward market. This trade has very little carry cost, extremely low volatility and, if our analysis proves correct, it will have a substantial payoff. This is not just a bet on devaluation but on a rising probability of devaluation over the long run. Even if the kingdom does not devalue its currency, three-year currency forwards will, at some point, start pricing some devaluation risk. That will be sufficient to make this trade profitable. Oil Prices: Low For Longer The spot crude oil price has rallied close to 30% since October 29, 2020 despite the decline in the global mobility index on the back of renewed lockdown measures in Europe and the US (Chart 1). The mobility index’s weak reading is a clear sign of reduced current oil demand in major DM and in some EM economies.1 How do we square the relapse in global mobility with the latest rebound in spot oil prices? Odds are that investor buying has been largely responsible for the latest rebound in crude prices from early November lows. Investors flocking to oil is also consistent with purchases of assets that benefit from the reflation trade. Importantly, the spot crude price has recently risen more than medium-term (two-year) forwards (Chart 2) and, critically, long-term (three- and five-year) forwards have failed to advance. Given subdued current demand for crude, this also suggests that the spot price has been supported by investors. Chart 1Spot Oil Prices Have Diverged From Short-Term Demand Chart 2Spot Oil Prices Are Above Forward Prices Moreover, the strong rise in Chinese oil imports since May was partially due to inventory restocking. Recently, Chinese imports of crude oil and petroleum products have weakened as the restocking phase comes to an end (Chart 3). Going forward, we assume Chinese final demand for oil and oil products will be running at 3-4% in the coming years, in the best case scenario. Global oil demand will rise next year, as the deployment of coronavirus vaccines revive mobility and travel. However, greater demand will be offset by higher production as OPEC+ producers continuously increase oil output in 2021 (Chart 4). Chart 3Chinese Oil Imports Have Slowed Chart 4Oil Production Will Rise For Major Producers Beyond next year’s normalization period, the rotation towards renewables and green technology will emerge as headwinds to the oil market. On the supply side, the group of OPEC+ producers has been suppressing oil production. Given the weak state of a number of petro-economies and their troubling socio-political situations, these producers, particularly Russia, Nigeria and Iraq, are incentivized to raise their crude production. In the long run, the OPEC+ arrangement of suppressing crude output will likely prove unsustainable. Ultimately, every producer’s overreaching objective is to maximize the net present value of its potential cash flow from oil. Due to inflation, $45 today is worth more than $45 in five or ten years. OPEC+ production constraints work as long as oil producers believe this setup is maximizing the net present value of their very long-term cash flow from oil. When producers realize that, in the long run, oil prices will remain under $50, they will rush to produce and sell as much as they can at current prices. Early signs of such behavior are already occurring as the UAE’s state-run oil company plans to invest in oil production at a time when the country is producing well below its capacity. Remarkably, the five-year forward oil price is now at $48 per barrel, which is close to its lows in April 2020 and January 2016 (Chart 5). A break below its previous lows will send a signal to oil producers, incentivizing them to produce and sell more oil at current prices. In short, tensions among OPEC+ members will rise over capping crude output. This was demonstrated in last week’s OPEC+ meeting during which members faced difficulty in reaching an agreement. These tensions will grow and will eventually lead to either sharply increased production quotas or reneging on the agreement. In addition, US President-elect Joe Biden and his new administration will likely start talks with Iran and provide some sanction relief. The motive is to undo some of Trump’s policies and re-establish some of Obama’s signature foreign policy accomplishments. The outcome of a U-turn in the US approach to Iran will be an increase in Iranian crude output (Chart 6). Chart 5Long-Term Oil Prices Remain Depressed Chart 6Iranian Oil Production Will Increase With Biden's Presidency Bottom Line: Oil prices will remain depressed going forward, averaging $40 in 2021 and $35 in 2022. These estimates form the basis of our analysis regarding Saudi Arabia’s required macro adjustments. Fiscal Tightening: How Much And For How Long? The Saudi government has already undertaken substantial fiscal tightening this year. Going forward, the government projects that fiscal spending in nominal terms will contract by 7.3%, 3.5% and 1.5% in 2021, 2022 and 2023, respectively (Chart 7). Under these assumptions, and if oil prices average $40 in 2021 and $35 in 2022, the fiscal deficit will be wide at –14% and –16% of GDP (Table 1). Chart 7Saudi Arabia: Fiscal Austerity Will Persist Table 1Projections For Oil Prices, Fiscal Balance, BoP And SAMA’s FX Reserves Nevertheless, fiscal austerity cannot be sustained for many years. Fiscal fatigue could set in as tight policy becomes socially and politically unacceptable. Hence, risk to the government’s spending projections is to the upside. The budget deficit, however, is not an ultimate constraint. Authorities can allow the budget deficit to balloon and finance it via bond issuance. In our simulation, we assume the government will finance about 25% of the fiscal deficit in 2021 and 2022 by issuing US dollar-denominated government bonds. The rest will be financed by local currency bond issuance. This raises the question whether the kingdom has sufficient savings to domestically finance its large fiscal deficits. As we wrote in the previous report, this is not a pertinent question. The basis is that when domestic commercial banks buy government bonds, they create new money/deposits “out of thin air.” This is true for any country in the world that has its own currency. If large fiscal deficits are only financed by domestic banks purchasing local currency bonds, it will lead neither to higher interest rates nor to the crowding out of the private sector. This is the least painful adjustment and the Saudi authorities could be tempted to resort to this solution, i.e., urge commercial banks to buy a substantial portion of local currency government bond issuance. So far this year, 20% of Saudi Arabia’s fiscal deficit has been financed via the issuance of US dollar bonds, 55% by local currency bonds, and 25% by drawing on the government's US dollar reserves at the central bank. Commercial banks’ purchases of local currency government bonds can continue for many years, allowing the kingdom to finance its budget deficits. The central bank may or may not need to provide commercial banks with liquidity (excess reserves) for banks to continue doing it. Chart 8Saudi Arabia: Broad Money And Excess Reserves Excess reserves are created by central banks “out of thin air” so they do not represent a major constraint. The ratio between broad money supply and excess reserves represents the money multiplier. Chart 8 illustrates there is no strong or constant relationship between Saudi commercial banks’ excess reserves and broad money (M3) creation. The latter could fluctuate, i.e., commercial banks could create more or less new money/deposits for the same level of excess reserves provided by the central bank. Critically, on aggregate, the commercial banking system does not lend out or part with excess reserves when it originates loans or purchases securities, except in cases where the counterpart is the central bank, as we demonstrated in our October 22 and January 16 2020 Special Reports. Bottom Line: The purchase of debt securities, including government bonds, by commercial banks is nothing more than debt monetization. Hence, any country can finance its fiscal deficit by encouraging domestic commercial banks to purchase local currency government bonds. Ultimate Macro Constraints The ultimate macro constraint for any country when budget deficits are financed by local commercial banks is inflation and/or downward pressure on the currency. Monetization of government debt could eventually be problematic in Saudi Arabia because the country pegs its currency to the US dollar. The risks to the exchange rate peg due to mushrooming money supply will ultimately limit the government’s ability to rely on commercial banks to finance its budget deficits (Chart 9). Chart 9Saudi Arabia: Divergence Between Broad Money And FX Reserves Will Continue For Now Another Achilles’ heel of this economy is its dependence on imports. Structurally, the economy is plagued by low productivity and a lack of domestic productive capacity. Consequently, any boost to domestic demand from fiscal spending will translate into higher imports as well as increased remittance outflows from foreign workers who dominate Saudi Arabia’s workforce. Ultimately, pressure on the current account balance will build as the expansion in domestic demand leads to US dollar outflows. Both FDI and portfolio inflows have been meager and will stay depressed if oil prices remain low, since foreign investors will be hesitant to invest in this petro-dependent economy. Amid a deteriorating balance of payments, the only way to defend the currency peg will be for the central bank to sell its foreign exchange reserves. Chart 10 (top panel) shows that the central bank’s foreign reserves have been shrinking while broad money supply has been expanding rapidly. Chart 10The FX Reserves-To-Broad Money Supply Ratio Will Fall Close To 0.5 In 2022 Such dynamics will persist in the coming years. As a result, the foreign exchange reserves-to-broad money ratio will drop from 0.85 today to 0.68 by the end of 2021 and 0.53 by the end of 2022 (Chart 10, bottom panel). There is no threshold for this ratio or any other financial and economic variable to gauge when the peg will have to be adjusted. In the case of Saudi Arabia, de-pegging or devaluing the currency carries major political implications. Authorities will be reluctant to do it before Crown Prince Mohammed bin Salman becomes king. Nevertheless, long-term currency forwards could start pricing a probability of such currency adjustments earlier than it eventually occurs. The Risk Premium In Currency Forwards The risk premium in the long-term currency forwards will widen as (1) oil prices stay low for longer (Chart 11), (2) Saudi Arabia engages in some form of covert debt monetization, and (3) the traditional pillars of US-Saudi relations gradually erode. Chart 11Bet On A Rising Probability Of Devaluation Chart 12Underweight Saudi Versus EM Equities US-Saudi relations will likely sour in the coming years stemming from the Biden administration’s engagement with Iran. Having reached self-sufficiency in energy production, the US will, in the long run, have less incentive to be involved in the region and defend its allies. Together, these factors could raise the geopolitical risk premium in the Saudi riyal forwards. Poor domestic growth, as well as a rising risk premium due to devaluation, bodes ill for equities. Investors should consider underweighting Saudi stocks within an EM equity portfolio (Chart 12). For credit investors, we recommend underweighting both Saudi sovereign and corporate spreads in an EM credit portfolio. Lower oil prices will force more borrowing and start eroding the balance sheet of the government and corporates. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 The global index is constructed based on data from 25 developed and developing countries, including India but excluding China.
Chart II-1Nigeria: Poor BoP Position The Nigerian naira is facing a considerable risk of major devaluation stemming from strains on its balance of payments (BoP). That said, the risk of a sovereign default is very low over the next 12-18 months. Nigeria suffers from large external imbalances in an environment of low oil prices and dreadful FDI inflows. The nation’s current account deficit is wide at 5% of GDP and its foreign currency (FX) reserves are low (Chart II-1). Importantly, oil prices have hit a critical technical resistance – their 200-day moving average – and have relapsed (Chart II-2). Global oil demand weakness stemming from some renewed tightening of lockdown measures will result in lower crude prices. We at BCA’s Emerging Markets Strategy team expect Brent prices to be in a trading range of $35-$45 over the next 12 months.2 An Optimal Macro Adjustment A low oil price environment creates a dillemma for Nigeria’s policymakers given their limited FX reserves. They can either (i) draw down FX reserves to support the exchange rate, or (ii) preserve FX reserves and allow a major currency devaluation. So far, Nigerian authorities have avoided these options by resorting to strict capital controls and limiting imports. Yet, capital controls are derailing much needed foreign capital inflows in general and FDIs in particular. These capital account controls are also restricting the ability of domestic firms to access US dollars to service their foreign debt payments, undermining the confidence of foreign investors and multilateral creditors. Allowing currency depreciation is the least-worst macro policy solution. Propping up the currency by administrative restrictions amid low oil prices will foster various imbalances impeding the nation’s structural adjustments and its potential growth rate. Remarkably, Nigeria’s current account excluding oil has been structurally wide, a sign of weak domestic productivity and a non-competitive currency (Chart II-3). Chart II-2A Relapse In Oil Prices Is Likely Chart II-3Nigeria Has A Current Account Deficit Ex-Oil Bottom Line: Capital controls and import restrictions are impeding FDIs and productivity growth in this most populous African country (Chart II-4). While a steep devaluation will spur inflation in the short run, a cheapened currency and the abolishment of import and capital controls will help to attract foreign capital that the nation desperately needs. Running Out Of FX Reserves Critically, the Central Bank of Nigeria (CBN) is running out of FX reserves: Nigeria’s foreign exchange (FX) reserves are very low at $35.6 billion. That compares with foreign debt obligations (FDOs) of $28 billion in the next 12 months and foreign funding requirements of $47 billion in the next 12 months (Chart II-5). Chart II-4Nigeria: Weak FDI = Low Productivity Chart II-5Nigeria: Large Foreign Funding Required In Next 12 Months FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. Meanwhile, foreign funding requirements is the sum of the current account deficit and FDOs. FDI inflows were a mere $2.5 billion in 2019 compared with a $20 billion current account deficit. Along with foreign portfolio inflows, FDI inflows will remain depressed so long as capital controls persist. The FX reserves-to-broad money ratio currently stands at 0.4. A ratio below one indicates foreign currency reserves do not entirely cover currency in circulation and local currency deposits. How much should the exchange rate be devalued versus the US dollar for this ratio to reach 1? For the broad money supply coverage ratio to be equal to 1, the currency must depreciate by 56% against the US dollar. Bottom Line: CBN’s FX reserves are insufficient to maintain the current de-facto crawling currency peg in the long run. No Worries About Sovereign Credit For Now Chart II-6Nigeria: Low Public Debt Burden While the Nigerian government is reeling from lower oil prices, the likelihood of a sovereign default is presently low. Public debt is low, currently standing at 22.5% of GDP. Notably, foreign debt represents nearly 30% of overall public debt or 6.5% of GDP. Moreover, only 40% of external debt (3% of GDP) is owned to private foreign investors (Chart II-6). The rest is split between bilateral and multilateral creditors. Foreign bilateral and multilateral debt is easier to renegotiate. While overall (domestic and foreign) debt servicing costs have risen to 55% of government revenues, foreign currency debt servicing costs only represent 2% of overall revenues. Provided foreign public debt servicing is minimal, even a large currency depreciation will not make public debt dynamics unsustainable. Crucially, a substantial currency devaluation will ameliorate the fiscal position. A large share (about 55%) of fiscal revenues come from oil, i.e., they are in US dollars. Conversely, expenditures are in local currency terms. As a result, currency depreciation will boost revenues but not expenditures, narrowing the budget deficit. According to the newly revised budget for the 2020 fiscal year, fiscal spending will grow by 8.7% in nominal terms but most likely contract in real terms (Chart II-7). Overall, the fiscal balance will widen to 3.65% of GDP in 2020 according to government projections. In nutshell, policymakers refrained from large fiscal stimulus amid lockdown measures earlier this year. This is bad for the economy but positive for the trajectory of public debt. Finally, public debt dynamics are presently not worrisome with nominal GDP growth above local interest rates (Chart II-8). Chart II-7Nigeria Will Run Tight Fiscal Policy Chart II-8Nigeria: No Public Debt Sustainability Problem Bottom Line: The risk of a sovereign default is low in the coming years. The low starting points in both public debt levels and debt servicing costs will allow the government to boost fiscal spending to support the economy. Investment Implications Overall, a currency devaluation will help restore balance of payment dynamics without causing a major stress for sovereign credit. A 25-30% devaluation over the next 12 months will be the least-worst policy choice. Currency forwards are currently pricing a 20% depreciation in the naira versus the US dollar in next 12 months (Chart II-9). Yet, the average black market exchange rate, currently at around 470, implies almost a 25% discount from the current official rate. Sovereign credit spreads are presently tight (Chart II-10). Investors should consider buying Nigerian sovereign credit only after a substantial devaluation takes place. Chart II-9Naira Forwards Discount Will Widen With Lower Oil Prices Chart II-10Nigeria: Buy Sovereign Credit After Devaluation Finally, equity investors should continue avoiding the local bourse. Due to capital controls, the latter is uninvestable for now. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 2 This differs from BCA Commodity and Energy Strategy service’s expectation that Brent prices will average $65 in 2021.