Returns or Reforms? Taking Stock Of Pakistan’s MSCI Upgrade

Market Reaction to Pakistan's MSCI Upgrade

Investors braced themselves as the KSE100 dipped 3.6% following MSCI’s decision to reclassify Pakistan as an emerging market. Pakistan's MSCI upgrade is an improvement from its previous frontier market designation. The decline, largely driven by foreign fund outflows to the tune of $82 million on the eve of the reclassification, was catalyzed by concerns about Pakistan’s rapidly growing current account deficit and strengthening currency.

However, economic theorists vividly—and unanimously, mostly—assert that the existence of a current account deficit is neither good nor bad for an economy. Pakistan’s current account balance, however, has exhibited a startling growth rate, trebling over the ten month period to April according to the State Bank of Pakistan. Historically an export-driven economy, Pakistan’s exports are rendered less competitive by the appreciation of its currency, the rupee.

A Sound Explanation?

These fundamental macroeconomic issues are indeed detrimental to the health of Pakistan’s economy. Yet investors’ decision to, on aggregate, emphasize these data immediately prior to Pakistan's MSCI upgrade is intriguing. Especially given the KSE100’s blockbuster year-to- date performance leading up to the reclassification, having generated a return of 10.5% versus the Dow Jones Global Index’s 10.6%. The aforementioned macro indicators will continue to drive Pakistan’s performance, and a sudden market focus on these indicators could be chalked up to a self-fulfilling prophecy phenomenon or a behaviorally driven reflex. Market participants might be prudent in assessing the differential impacts of the reclassification itself. After all, does an emerging market designation worsen the current account deficit’s implications?

Pakistan's MSCI Upgrade
Two traders sit in front of screens monitoring stocks at the Karachi Exchange.

Dichotomous Views Between MSCI & Fund Managers

Consider the discrepancy between the views of MSCI and fund managers. MSCI’s decision was guided by improvements in liquidity and SME regulations, diminishment of information costs through reforms including the Pakistan Unified Corporate Action Reporting System, and additional impediments to moral hazard via restrictions on Negotiated Deal Market transactions, for instance. MSCI guesstimates that the benefits of these reforms warrant an upgrade, net of potential costs.

Fund managers, in contrast, express skepticism over the upgrade. Asset managers such as Union Bancaire Privée are yet to find valuable, “high-quality” securities in the Pakistani equity universe. Others, including Renaissance Capital, a London-based investment bank, focus their attention on political corruption. Specifically, the sluggishness of Pakistani Prime Minister Nawaz Sharif’s privatization program, coupled with an expected spending spree leading up to the elections in 2018, are key hindrances to genuine improvements in Pakistani economic prosperity, says Daniel Salter, Head of Equity Strategy at Renaissance Capital. Even still, financial commentators such as the Business Recorder herald the inevitable boom Pakistan is to enjoy as a result of, say, the China Pakistan Economic Corridor. Such predictions imply juicy returns for infrastructure stocks, particularly in the context of Pakistan’s alleged improving economic stability.

Useful Perspectives on Pakistan's MSCI Upgrade

Contradictory news is an ancient phenomenon. So what matters, returns or reforms? I offer two broad views, which aren't necessarily mutually exclusive. An astute trader may rightly focus on the KSE100’s appetizing volatility and likely enjoy a decent yield plus a diversification benefit. A longer-term investor may incorporate the same perspective, or may instead focus on the intrinsic value of the shares constituting the KSE100.

In particular, an investor should be vary of the impact that effective corporate governance, shareholder rights, and regulation pose on the cash flows a stock is theoretically valued through. The current state of said factors implies a risk premium for the cash flows accorded to KSE100 stocks, which itself presents an opportunity to buy at current levels and profit off improving conditions. Even still, a longer-term investor can enjoy the diversification opportunity and the prospect of outsized capital gains. Further, risk can be constrained with, for instance, rolling options strategies such as selling calls on the KSE100 index.

Remember, research has found that hedge funds tend to be net sellers of liquidity; shorting highly liquid securities to purchase illiquid securities. On a global scale, the KSE100 may aptly be considered an index of illiquid securities.

Remember also that the Finance and Law academic literature has made strides in the treatment of corporate shares that exist within a suboptimal regulatory framework.

Shehryar Riaz

Shehryar Riaz

Jack of all trades, master of none. [Muhammad {Shehryar} Riaz]

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