Karachi, May 15, 2018 (PPI-OT): Pakistan Economy: Rising oil prices add on to the economic woes
Benefiting from a prolonged period of low oil prices and fast-paced growth momentum (largely on CPEC related developments), the recent resurgence in oil prices to its 3.5yr high calls for an update in macro assumptions. We believe oil prices are likely to hover around these levels (Arab light to average at US$70/bbl in FY19F vs US$60/bbl earlier) backed by geopolitics setting the roadmap (likely fallout of Iran oil in light of US withdrawal from the JCPOA) and planned ARAMCO IPO (expected in 2019). Consequentially, CPI inflation is estimated to rise to 6.13%YoY/6.55%YoY in FY19F/CY19F (vs. 5.76%YoY/5.9%YoY earlier with oil prices assumed at US$60/bbl). In this backdrop, we believe MPC can take a more hawkish stance in setting the policy rate. Additionally, pressures on the external account are likely to remain elevated in the upcoming year where current account deficit is likely to be recorded around the same level at 4.9% of GDP (US$16.2bn) in FY19F (vs. FY18E). Looming macroeconomic headwinds can potentially dampen the positives arising out of growth momentum and can give rise to a defensive investor mindset. In this regard, sectors like banks (anticipation of rate hike), E and P (uptick in profitability), Energy (US$ hedged) and export revenue based sectors should thematically be considered to counter market volatility.
CPI inflation: Average CPI inflation for 10MFY18 has been recorded at 3.77%YoY mainly on the back of subdued food prices. However, this trend is likely to reverse as inflationary pressures build up on the back of higher oil prices (+52% in FYTD) and delayed impact of FX movement (9.4% depreciation in FYTD) while Ramadan effect is yet to kick in. Assuming a 60% pass through impact, average Arab light at US$70/bbl in FY19 is expected to lift CPI inflation reading to 6.13%YoY/6.55%YoY in FY19F/CY19F (vs. 5.76%YoY/5.9%YoY at US$60/bbl). Additionally, other factors are also expected to contribute towards higher inflation including the imposition of additional FED on cigarettes and impact of hike in medicine prices under the drug pricing policy 2015 (yet to be implemented). That said, supply dynamics in heavy weight food index would remain a dominant factor in determining CPI inflation where most of the prices remain administered by the GoP.
Monetary policy: We believe MPC to take a much more hawkish stance in setting the monetary policy to maintain real interest rates at comfortable levels (+130bps avg. in FY19 vs. 200bps since Jul’09) keeping in view the rising inflation. In this regard, using IFB reaction function we estimate a cumulative 175bps interest rate hike with TR/DR ending at 8.25%/8.50% by Jun’19 (vs. 100bps assumed earlier) where we believe MPC should increase interest rates in small phased increments to minimize the potential negative impact on growth momentum.
External account: Pressures on the external account are likely to remain elevated where current account deficit is likely to be recorded at 4.9% of GDP (US$16.2bn) breaching the GoP’s target of 4.0% of GDP (US$13.3bn). This is despite incorporating healthy growth in exports (11.3%YoY in FY19F), gradual reduction in FO imports (~2.6mn tons reduction in FY19F) and slowdown in machinery imports growth (as 43% of energy-early harvest projects reach completion), with the imbalance being driven by higher oil import bill (+16.8%YoY in FY19F). Consequently, this is likley to restrict SBP’s ability to maintain PkR /US$ parity at these levels with potential 4.5% depreciation in FY19F (parity to end at ~PkR121/US$) considering outflows such as redemption of US$1bn Eurodollar bond and ~US$617mn payment to the IMF scheduled in FY19.