Potential downgrade to frontier markets could prove beneficial to capital market: experts

KARACHI: A potential downgrade to the Frontier Market Index from Emerging Market Index could prove beneficial for the Pakistani capital market as it is expected that this would lead to increase in foreign inflows due to Pakistan’s potential weight in the Frontier Index, experts said.

Morgan Stanley Capital International (MSCI) will announce its decision to re-classify Pakistan from Emerging Markets Index to Frontier Markets Index (FM) on September 07, 2021.

MSCI proposed this reclassification earlier this year in June. It will be put into effect in November 2021 to coincide with November 2021 Semi Annual Index Review.

MSCI is one of the various global index providers which provide indexes for fund managers to track. Presently, Pakistan is included in the MSCI Emerging Markets (EM) Index.

MSCI’s classification is not among those rating agencies that track international businesses and economies, experts said. It is also not like the global bodies IMF or World Bank that evaluate and rank real economies. MSCI then may be understood as an independent agency that issues periodic rankings based on its specific criteria, that investors anywhere in the world are not mandated to follow. Moreover, MSCI does not consider economic development as a factor for countries in the EM or Frontier Index and bases its decision only on the size and liquidity of the market and how investors perceive accessibility of a market.

In June 2016 MSCI had classified Pakistan to Emerging Markets status from Frontier Markets status, coinciding with the May 2017 Semi-Annual Index Review.

MSCI to begin consultation on proposal to downgrade Pakistan

Earlier, Pakistan was part of the MSCI Emerging Market Index between 1994 and 2008. However, MSCI removed Pakistan from the said index and classified it as a “standalone country index” due to imposition of the floor in the market in 2008. Subsequently, Pakistan was placed in the Frontier Index in 2009.

In 2017, 16 stocks were included in the MSCI Frontier Market Index, donating a weightage of 9 percent whereas to be included in the Frontier Index only two securities are required to be eligible from the country. Accordingly, Pakistan was well above the minimum benchmark.

After the upgrade to Emerging Market (EM) status, only 6 stocks were included in EM, resulting in a weightage of 0.14 percent. It is worth noting that minimum three securities are required to remain eligible for remaining in the Emerging Index. Presently only 3 Pakistani securities are in EM Index and these also do not qualify for EM Index.

The reclassification has adversely affected the capital market as the weight of Pakistani securities in Emerging Index has consistently remained extremely low, i.e. as low as 0.02 percent presently. Therefore, fund managers tracking the Emerging Index can afford to not invest in the Pakistani market and retain a minor tracking error.

Fund managers are generally permitted under their constitutive documents to keep a tracking error, i.e. not to strictly follow an index and maintain certain variation thereby not investing in securities considered to be insignificant. Therefore, by becoming part of the Emerging Index Pakistani capital market became irrelevant for fund managers globally. Comparatively in 2017 Pakistan had an estimated weight of 9 percent in the Frontier Index thus making it unviable for fund managers tracking this index to not invest in Pakistan.

In view of the announcement to upgrade Pakistan to EM, market developed expectations of heavy foreign investments and resultantly the KSE-100 Index peaked above 52,000 points in the month of May 2017. However, subsequent to the date of transition a rapid decline was observed. This was primarily led by foreign selling due to exit from Frontier Index and lack of buying by foreigners as a result of entry into the Emerging Index. By the end of June 2017 KSE-100 Index had dropped to 46,565 points, with a further decline to 40,471 points by December 2017. The high of May 2017 has not been witnessed again in the preceding four years. In a span of a little over a month, i.e. May 01 till June 06, 2017, there was foreign selling worth approximately Rs 20 billion ($193 million) in the Pakistani capital market.

MSCI proposes putting Pakistan back into MSCI-FM

Moreover, PSX data also shows that foreign holdings under SCRA since January 2017 show a declining trend. It is worth noting that over 20 percent of the foreign capital in Pakistan eroded within a little over a year of transitioning to the Emerging Index, with a total decline by 46 percent over four years.

PSX data also showed that in addition to foreign flow of investments, there was an evident impact on the trading activities in the market. Turnover and traded value reduced significantly until recent recovery after June 2020.

Presently the numbers of constituents in EM Index are 3 which represent a weightage of 0.02 percent. As per MSCI no Pakistani stock qualified for EM Index and Since the November 2019 SAIR, there have been no securities in the MSCI Pakistan equity universe that meet the EM Size and Liquidity criterion under the MSCI Market Classification Framework and Index continuity rules were applied to artificially maintain 3 constituents. Presently, three securities, i.e. HBL, MCB and Lucky, are in the Emerging Index. All three securities are significantly below MSCI’s Full Market Cap and Free-Float Market Cap thresholds and are being retained due to MSCI’s index continuity rules. Earlier, Engro was removed in November 2017, while UBL and Lucky Cement were removed in November 2018 from the Emerging Index due to falling short of the above thresholds. In May 2021, OGDC were removed and Luck Cement was added.

If MSCI decides to downgrade Pakistan into the Frontier Index, it would result in a similar situation where any fund managers which have invested in Pakistan and are tracking the Emerging Index would pull out while investors tracking the Frontier Index would bring in capital, they said.

However, a potential downgrade to Frontier Index could prove beneficial for the Pakistani capital market. It is expected that this would lead to an increase in foreign inflows due to Pakistan’s potential weight in the Frontier Index.

Copyright Business Recorder, 2021