Pakistan's induction into MSCI index: Analysts see $600 million portfolio inflows from EM funds

Pakistan's "highly likely" induction into the emerging market (EM) index, equity analysts estimate, would lead to a gross inflow of $600 million by the EM passive funds into the local bourse. Although Pakistan's weight in EM would be much smaller, the $1.4-1.7 trillion funds tracking EM were much larger than $17-20 billion funds tracking FM, said analysts in a research note issued by Topline analysts on Friday. "Our back of envelope calculations suggests gross inflow of $600 million by EM passive funds," viewed Saad Hashemy at Topline Securities.
In a press statement on Wednesday, Morgan Stanley Composite Index (MSCI) said it would be announcing results of its 2016 Annual Market Classification Review on June 14. According to analyst Saad, there were three possible outcomes of MSCI's much-awaited announcement: Pakistan being upgraded to EM, the decision is deferred for a year and the MSCI decides not to upgrade Pakistan. "In our view, Pakistan's induction into the EM index is highly likely and in line with market's expectation," he said.
The latter outcomes, although less likely, would be equally negative for the market as recent rally, led by index heavyweight stocks, has been primarily fueled by expectations of EM reclassification, he added. Presently, Pakistan is in MSCI Frontier Markets (FM) Index and there is expectation that it would be upgraded to MSCI Emerging Markets (EM) Index.
Pakistan has 8.7 percent weight in MSCI FM Index and 8.5 percent in MSCI FM small cap index. In case of reclassification, number of constituents of MSCI Pakistan Index is likely to drop from 16 to 9 with share in MSCI EM to fall to 0.19 percent. In case of up-gradation, Saad said, there would also be an outflow from the FM funds, which would lead to lower net inflows. "We expect reclassification to trigger rebound in Pakistan market from current forward PE of 8.2x," he said.
This is based on similar upsurges witnessed by Qatar and United Arab Emirates (UAE) markets, which were up around 40 percent in 12 months following announcement of reclassification to EM. Consequently, Qatar and UAE Market's PE improved from 10.8x and 10.2x to 17.1x and 15.2x, respectively. Saad views that even though Pakistan's share would be significantly lower in EM compared to FM, its improving macros and upside from China-Pakistan Economic Corridor (CPEC) would prove to be compelling story in the EM universe.
"This should attract investors despite its relatively small size," he says. In a recent simulation, MSCI estimates Oil and Gas Development, Habib Bank, MCB Bank, United Bank, Lucky Cement, Fauji Fertilizer, Engro Corporation, Hub-Power Co and Pakistan State Oil to be included in the MSCI EM index. Pakistan remained in the MSCI EM Index during 1994-2007, but was removed in December 2008 due to price floor. In May 2009, Pakistan was shifted from standalone to FM Index.
Pakistan has met all quantitative criteria for up-gradation to MSCI EM. "Currently, there is a questionnaire circulating among market participants on Pakistan's reclassification after which a decision would be taken," said Saad. The feedback, he said, was being taken on concerns over: whether it is too early to reclassify Pakistan to EM, fewer market constituents and smaller market capitalization and market accessibility. As per MSCI, Pakistan Market has grown significantly with improvement in liquidity. "MSCI believes that previous concerns of Pakistan market failing to meet size and liquidity criteria, should the market face negative pressures, have reduced," he said.
MSCI has also acknowledged various reforms that have been recently implemented by Pakistan. These include, launch of Pakistan Unified Corporate Action Reporting Systems (PUCARS) at Pakistan Stock Exchange (PSX), restrictions on Negotiated Deal Market (NDM) transactions, foreign institutional investors to be taxed separately and withdrawal of exemption from withholding taxes (WHT), approval of SME regulations and development of Online Complaint Management System.