ISLAMABAD - A depreciation of the Pakistani rupee is now a high-probability event. With external debt at $93 billion or 29 per cent of the national GDP, I am alarmed by the significant deterioration in the State Bank of Pakistan's hard currency reserves from $16 billion to a mere $12 billion in the past year.
There is no time for Pakistan to issue another sovereign Eurobond as the PML-Nawaz government's term ends in May.
As if political risk was not bad enough, Pakistan faces a higher current account deficit due to CPEC-related outflows and the rise in Brent crude prices.
A Lula win in Brazil or a López Obrador victory in Mexico could easily trigger emerging markets contagion at a time of rising Federal Reserve monetary tightening. Trump's tariffs against China could not have come at a worst time for Pakistan.
The IMF projects Pakistan's current account deficit will rise to $15.7 billion or 4.8 per cent of GDP. Pakistan also faces an external financing need of $24 billion and a debt service cost $6.3 billion or 26 per cent of exports.
It is alarming that the SBP's hard currency reserve have fallen so significantly even though Islamabad has borrowed in the eurobond market only four months ago and has access to international commercial banking lines.
The Achilles heel of Pakistan, as ever, is the luxury import appetite of its elite (no shortage of Beamers and Benzis in Clifton/Defence!), its Rs90 billion circular debt, its poor tax collection/GDP ratio, its inability to accelerate export growth, its disproportionate, Prussian scale, military budget and the weakness (both real and induced by the deep state) of its democratic institutions.
The prospect of Imran Khan's PTI in coalition with Asif Zardari's PPP and smaller parties, as happened in the senate, winning the July 2018 general election is a nightmare for any international investor, the reason offshore money has been selling Pakistani equities. I was stunned to see the turnover on the Karachi stock exchange on a day I was in town last week was a mere $27 million, less than the notional size of an average day on my trading desk.
Pakistan is thus very vulnerable to both domestic and external financial shock in the summer and autumn of 2018. I do not remotely expect a sovereign debt crisis. The IMF's implied risk neutral sovereign probability of default is a mere 6.5 per cent and the credit default spread is high (but not draconian) at 342 basis points.
Yet I cannot see how Pakistan can escape a depreciation of the rupee under its central bank's managed exchange rate regime and would not be surprised to see the Pakistani rupee fall to 120 against the US dollar by year end 2018.
This conviction has profound implications for any strategic view on Pakistani equities. The Karachi index trades at 9.4 times earnings, far below the MSCI Asia ex-Japan valuation multiple of 13.6 times earnings.
Pakistani equities also offer a dividend yield of 5.3 and 3-year rupee bonds auctioned by the central bank yield 6.8 per cent. Yet my rupee view wants me to position money into OGDC and Pakistan Petroleum, who benefit from a rise in US dollar revenues if the rupee tanks while local operating cost decline.
Fears of a rise in the debt receivables could pressure Hub Power down to its 52-week low at 89, where I find it irresistible. Lucky Cement and United Bank are my other favourite blue-chips, though not at current prices.