Downgrade by global index provider could be boon for Pakistani equities

Published September 5, 2021
The MSCI placed Pakistan in the FM index in 2009 after keeping it in its standalone country index following the 2008 stock market crisis. — MSCI website/File
The MSCI placed Pakistan in the FM index in 2009 after keeping it in its standalone country index following the 2008 stock market crisis. — MSCI website/File

KARACHI: Brokerages expect an increase in foreign investment in equities should the MSCI, a global index provider, decide to downgrade Pakistan from the emerging market (EM) index to the frontier market (FM) index in its September 7 announcement.

“Foreign investment in Pakistan should rise if it’s reclassified to the frontier market,” said Shahid Ali Habib, CEO of Arif Habib Ltd (AHL), while speaking to Dawn.

Global institutional investors often use indices like the ones provided by the MSCI to make passive investments in different countries. These index-tracking investors increase or decrease their exposure to a particular market in line with any changes in its weight or classification by the index provider.

A downgrade resulting in higher inflows may sound counter-intuitive, but most brokers insist that a higher weight in the FM index will attract increased foreign investment.

MSCI announcement due on Sept 7

“Within the FM space, there are very few markets that are viable for sizable allocations from foreign investors. Pakistan will be the third-most liquid market in FM after Vietnam and Bangladesh,” said Mr Habib.

International passive funds have “substantially” reduced their exposure to the local share market in recent years. They currently have approximately $70 million invested in Pakistani equities, he added.

At present, only three stocks from the Pakistan Stock Exchange (PSX) are part of the EM index and carry a negligible weight of 0.02 per cent. Even these stocks — Habib Bank, MCB Bank and Lucky Cement — are “significantly below” the prescribed free-float and full-market capitalisation thresholds. The MSCI is retaining them on the index only because of its “continuity rules”.

Next Capital CEO Najam Ali also believes a downgrade to the FM index will increase the foreign fund flows. “More companies will join. Initial estimates indicate 50-60 companies may become eligible,” he told Dawn.

The MSCI placed Pakistan in the FM index in 2009 after keeping it in its standalone country index following the 2008 stock market crisis. At the beginning of 2017, as many as 16 Pakistani stocks were part of the MSCI FM index carrying a collective weight of 9pc.

There was much jubilation in the run-up to the country’s reclassification in the EM index in May 2017. Brokerages released research reports telling local investors that the upgrade would attract up to half a billion dollars of foreign investment. Expectations of higher inflows pushed the KSE-100 index to more than 52,000 points in May 2017.

But the KSE-100 index dropped rapidly soon afterwards. Passive funds tracking the FM index sold their positions as soon as the reclassification took effect. However, a negligible weight of 0.14pc in the EM index at the time resulted in little foreign buying. Foreigners sold shares worth as much as $193m on a net basis in just over a month. Since then, foreign portfolio investment has consistently been either negative or extremely low.

According to Mr Ali, the situation deteriorated “economically and politically” in Pakistan and, as a result, more companies could not become part of the EM index. “It seems the EM investors then lost their interest as Pakistan’s weight became negligible.”

He said Pakistan’s move to the EM index in 2017 was a good opportunity to develop the market and served as an incentive for bigger companies to move up the ladder. “However, the country wasted that opportunity due to unstable economic and political conditions since 2017,” he noted.

Mr Habib of AHL said the economy imploded after the 2017 upgrade and the subsequent “big devaluation” gave foreign investors another reason to avoid Pakistan. “Right now, Pakistan is on a different economic footing. We have a story that foreigners can buy into. It trades at a significant discount with a forward price-to-earnings multiple of 6.5 as opposed to FM heavyweights with multiples of 11-23,” he added.

However, not all brokers foresee a rise in foreign investment in the likely case of a downgrade. Topline Securities CEO Mohammed Sohail believes foreign portfolio investment will not increase because of the MSCI’s upcoming announcement. “Foreigners are making good returns in the United States and large emerging markets. That’s why they’re not enthusiastic about investing in small frontier markets,” he said.

Published in Dawn, September 5th, 2021

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