Morgan Stanley Capital International (MSCI) has initiated a consultation to downgrade Pakistan from its index of emerging markets to a frontier markets classification. — MSCI website/File

Why Pakistan's expected MSCI downgrade to FM index may be a positive development

With a mere 0.02pc allocation in the EM index, it was hard for Pakistan to get the attention of emerging market fund managers.
Published July 6, 2021

Morgan Stanley Capital International (MSCI) has initiated a consultation to downgrade Pakistan from its index of emerging markets (EM) to a frontier markets (FM) classification.

The consultation period will last until October and the downgrade is likely in November 2021.

But this was expected.

That's because over the last two years, the Pakistan Stock Exchange has failed to meet the liquidity and market capitalisation requirements of an emerging market.

The news has had a polarising effect on the market – while some view the decision with dread, others are happy with the outcome.

A deeper study of the MSCI EM Index reveals that it is lopsided. The allocation for Pakistan stands at 0.02 per cent while almost 80pc of the index is allocated to China (39.59pc), Taiwan (13.87pc), Korea (13.04pc), India (9.96pc) and Brazil (4.97pc).

The remaining 23 countries account for 20.56pc collectively.

Clearly, it is unfair to compare Pakistan with the likes of China and that is why the frontier market is a natural and more appropriate classification.

However, total assets under management in frontier market funds have dwindled over the past few years and are now less than $5 billion. So while Pakistan's allocation in the MSCI Frontier Markets Index has been proposed at 2.3pc, the reclassification is likely to lead to outflows of more than $50 million.

When Pakistan was upgraded to the EM Index in 2017, Chinese A shares were not included. But later, China's inclusion crowded out most other markets.

In the short term, the outcome is generally positive but it was difficult for Pakistan to get the attention of emerging market fund managers with a mere 0.02pc allocation.

It was a rounding error and investors would rather spend their time looking at larger markets. At least among frontier markets, Pakistan will be hard to ignore.

In fact, it does not come as a surprise that most of the funds that have invested in Pakistan are already frontier market-focused.

On a longer timeline, however, the demotion is tragic.

In the 1990s, Pakistan was the darling of emerging market investors. As recently as 2005, Merrill Lynch had selected Pakistan as among the top three most-preferred markets in Asia.

The trading volume on the Karachi Stock Exchange was higher than most Asia Pacific markets such as Malaysia, Indonesia, and the Philippines.

A former chairman of the Securities and Exchange Commission of Pakistan (SECP) told me that in the 90s, the Chinese used to seek his advice on how can they learn from Pakistan.

The gap between market liquidity in India and Pakistan was not more than ten times (now it is more than a hundred times). The stock exchange in Turkey was only launched in 1986 and its founding team studied Karachi as a case study.

Looking at this past, the regression has been swift.

Ironically, this fall has been driven by ill-conceived regulatory initiatives over the 2008-2018 decade, in part due to policies by people who had little or no experience of global markets.

I remember in 2004, an argument was made in newspapers that a Tobin tax should be introduced in order to reduce trading volumes. Think about it: we were debating on policies to reduce, not increase, market liquidity.

Unfortunately, all those policies succeeded.

The result was that while the regulatory infrastructure grew, the market volume declined by 90pc, the number of new IPOs dried out and retail investors moved away to markets where regulators didn't exist — mainly real estate.

There is a direct negative correlation between the rise of Bahria Town and the demise of the capital markets.

But all is not lost. I am glad that there has been a marked change in the regulatory attitude since 2019.

The results are also evident. Trading volumes are up three times, new company registrations are at record levels and the number of IPOs in the fiscal year 2021 (eight) is the highest in a decade.

So while the popular myth is that the lack of activity in the capital markets is somehow linked to a lack of trust in brokers, actual data has proven this to be untrue. The only factor that changed between 2005 and 2008 and now after 2019 is regulatory attitude.

I hope the positive change stays and the forces which led to the 2008-2018 downfall don't return. The downgrade is the penalty for those times – a costly lesson for Pakistan.