When index creator MSCI announced in June that it was promoting Pakistan from a frontier market to a fully-fledged emerging market, it created something of a quandary for specialist frontier investors.
The move proved those investors had been right to invest so heavily in the country over the years. It also created a jolt that sent Pakistan’s stock market 5% higher in a matter of days. But it raised obvious questions about whether these funds could continue to invest in the market in future.
One frontier market-focused portfolio manager told FinanceAsia his fund would continue to invest in the country, arguing that MSCI index inclusion was not the only way to measure whether a market qualified as a ‘frontier’. But as the Karachi stock market continues to ascend, end-investors in frontier funds may balk at this logic.
The question will become more pertinent in May, when Pakistan will finally be included in the MSCI Emerging Markets Index after a long wait.
Until then, the country can get the best of both worlds, being seen as a frontier market but enjoying fund flows from some investors that want to stay ahead of the index-trackers.
But by the end of next year, it seems likely frontier investors will have increasingly started to decide that the country no longer offers the returns it once did.
Reform school
The evidence is hard to avoid. Pakistan’s stock market has offered eye-watering returns to investors, but the profits are not what they once were. The country’s KSE 100 index jumped by around 50% in 2012 and the same again in 2013. But in 2014, growth fell to around half of that level — and last year, the stock market closed slightly down.
The country will soon finish a three-year International Monetary Fund programme worth $6.2 billion in loans. In a sense, the successful completion of the programme is good news — giving further evidence of Pakistan’s transformation — but government officials will be going it alone at a time when the country faces real risks.
For one thing, public debt is a growing issue. Pakistan’s public debt is worth 65% of its economy, “well above the emerging market average” according to the IMF. This problem is exacerbated by the country’s shoddy, albeit improving, tax collection.
Pakistan also suffers from acute political risk. The long-running dispute with India, undoubtedly the biggest source of risk, appears to be getting worse.
India claimed in late September to have launched ‘surgical strikes’ in Pakistan, an apparent response to a terrorist attack on Indian soldiers. Pakistan, which has said it would respond to any border incursions, decided to deny any such thing had happened, calling it ‘an illusion’.
The country will certainly be helped by a growing relationship with China. The agreement to create a ‘China-Pakistan Economic Corridor’ — a series of roads, pipelines and ports connecting the two countries — is sure to give Pakistan’s economy a new source of demand.
But China is unlikely to push free market reform with the same vigour as the IMF. Under the IMF’s watch, Pakistan has made its central bank independent, scrapped the bulk of energy subsidies, and reduced power blackouts, especially for industrial consumers. There is still a long way to go, but the progress has been clear.
There is little doubt that Pakistan’s economy has improved tremendously in the last five years. But like a bodybuilder trying to pack on the muscle, the early gains are the easiest. Pakistan’s increasing maturity means that growth is likely to be harder to achieve — and that frontier investors are unlikely to be sated for long.
