pakistan economy 30-july-2009

8/14/2019 Pakistan Economy 30-July-2009

1/33 An InvestFinS S.A. group company

July 30, 2009

Pakistans economic stabilization indicators are set to recover further during FY10.Nevertheless, presence of a number of risks may place checks on the extent of economicgrowth. Revival of LSM sector will be the key to our FY10 GDP growth forecast, though supportfrom Agriculture and Services sectors will also play a role.

The FY10 fiscal policy, with a focus on countercyclical effects and crowding-in, has set a pro-Keynesian tone to spur economic growth. However, over-reliance on external funding and anoptimistic revenue target are main concerns regarding the effectiveness of such a fiscal policy.

In our view, recent global developments may act as counterbalancing forces for Pakistans

balance of payment posing threats on one hand and offering opportunities on the other. Webelieve these counterbalancing forces to remain somewhat in equilibrium, thereby improvingcurrent account balance only slightly.

Given the anecdotal evidences of a mildly positive world economic growth in 2010, oil pricesare expected to remain range-bound in FY10 a positive for imports. However, we expectexports and remittances to take the lagged hit of global economic crisis. Beyond FY10, theglobal economic recovery in the offing has a high probability of triggering Pakistans exports.

Owing to a mild improvement in current account balance, exchange rate may remain underpressure throughout FY10. We believe that the exchange rate is prone to further depreciationin FY10, though the extent of depreciation would not be of a kind witnessed in FY09.

Inflation has peaked in FY09 and high base effect is expected to drag it down to single digit inNov09. Although inflationary risks cannot be struck off, they would be a lot more confinedcompared to the previous fiscal year.

There are apparent pressure of high electricity charges and liquidity-induced demand pullforces once the high base effect runs out of breath. However, we expect combined impact of all these factors will be less severe in FY10.

FY10 is also expected to bring more softening in SBPs monetary policy stance. We believe thata considerable fall in sticky core inflation and the need to spur GDP growth will bring acumulative 250bps cut in Discount Rate by January 2010 Monetary Policy.

Macroeconomic Snapshot

FY08A FY09A FY10F FY11F FY12F

Real GDP Growth 4.1% 2.0% 3.1% 3.8% 4.4%Agriculture 1.1% 4.7% 3.5% 3.7% 4.0%

LSM 4.0% -8.2% 0.9% 3.2% 4.8%

Services 6.6% 3.6% 3.7% 4.0% 4.5%

CPI Inflation 12.0% 20.8% 9.7% 6.5% 5.2%

PKR/USD 62.6 78.6 82.5 83.8 86.3

6M KIBOR 10.2% 14.0% 11.2% 9.8% 9.3%

6M TBILL 9.7% 12.8% 10.9% 9.8% 9.4%

Source: Elixir Research

Economy in FocusELIXIR SECURITIES PAKISTAN

Real GDP Growth

Source: MoF

PKR/USD

Source: SBP

Haider Hussain

Economist

[email protected]

+92 21 247 0459

Combating Against the Odds!

55

6065

70

75

80

85

90

F Y 0 3

F Y 0 4

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0 F

6.8%

4.1%

2.0%

3.1%3.8%

0.0%

2.0%

4.0%

6.0%

8.0%

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0 F

F Y 1 1 F


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Economy: Combating Against the Odds!

4 ELIXIR SECURITIES PAKISTAN July 30, 2009

LSM Contraction led to the fall in GDP growth, thoughhigher agriculture sector growth provided some support

Squeeze in PSDP reduced the overall investment, butsavings rose owing to higher NSS rates on offer

Source: MoF, Elixir Research Source: SBP, Elixir Research

Demand-output gap has widened in FY09, which is amajor factor in igniting inflationary fire

IMFs loan agreement helped in halting furtherdepreciation of local currency

Source: MoF, Elixir Research Source: SBP, Elixir Research

0%

5%

10%

15%

20%

25%

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

Inves tmen t as % o f GDP Sav ings as % o f GDP

0%

5%

10%

15%

20%

25%

-200

300

800

1,300

1,800

2,300

2,800

F Y 0 0

F Y 0 1

F Y 0 2

F Y 0 3

F Y 0 4

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

Demand-Output Gap, PKR b n (LHS)

Headli ne Inflation (RHS)

0

2

4

6

8

10

12

14

60

65

70

75

80

85

A p r - 0

8

M a y - 0

8

J u n - 0 8

J u l - 0 8

A u g - 0

8

S e p - 0

8

O c t - 0

8

N o v - 0

8

D e c - 0

8

J a n - 0 9

F e b - 0

9

M a r - 0

9

A p r - 0

9

M a y - 0

9

J u n - 0 9

FX Reserves, USD bn (RHS)

PKR/USD (LHS)

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

Real GDP Gro wth

Agriculture Growth

LSM GrowthServices Growth


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July 30, 2009 ELIXIR SECURITIES PAKISTAN 5

Dependence of Import bill on oil prices has continued tobe a cause of concern

Despite a satisfactory performance amidst globaleconomic fallout, sustainability of exports remain anissue

Source: SBP, Elixir Research Source: SBP, Elixir Research

Base effect triggered an across the board fall in inflationduring FY09

Decline in inflation expectations has led to the fall inmarket interest rates


0

20

40

60

80

100

120140

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.54.0

A p r - 0

8

M a y - 0

8

J u n - 0 8

J u l - 0 8

A u g - 0

8

S e p - 0

8

O c t - 0

8

N o v - 0

8

D e c - 0

8

J a n - 0 9

F e b - 0

9

M a r - 0

9

A p r - 0

9

M a y - 0

9

J u n - 0 9

Import, USD bn (LHS)

Arab Lig ht, USD/bbl (RHS)

0%

5%

10%

15%

20%25%

30%

35%

40%

A p r - 0

8

M a y - 0

8

J u n - 0 8

J u l - 0 8

A u g - 0

8

S e p - 0

8

O c t - 0

8

N o v - 0

8

D e c - 0

8

J a n - 0 9

F e b - 0

9

M a r - 0

9

A p r - 0

9

M a y - 0

9

J u n - 0 9

Headli ne Inflation

Food Inflation

Core Inflation

9%

10%

11%

12%

13%14%

15%

16%

17%

A p r - 0

8

M a y - 0

8

J u n - 0 8

J u l - 0 8

A u g - 0

8

S e p - 0

8

O c t - 0

8

N o v - 0

8

D e c - 0

8

J a n - 0 9

F e b - 0

9

M a r - 0

9

A p r - 0

9

M a y - 0

9

J u n - 0 9

Discount Rate 6M T-Bill

6M KIBOR 10Y PIB

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

0.0

0.20.40.60.81.01.21.4

1.61.82.0

A p r - 0

8

M a y - 0

8

J u n - 0 8

J u l - 0 8

A u g - 0

8

S e p - 0

8

O c t - 0

8

N o v - 0

8

D e c - 0

8

J a n - 0 9

F e b - 0

9

M a r - 0

9

A p r - 0

9

M a y - 0

9

J u n - 0 9

Curr ent A/C Bal., USD bn (RHS)

Exports, USD bn (LHS)


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Macro Assumptions: SnapshotKey Macro Indicato rs FY09A FY10F FY11F Comments

GDP Growth 2.0% 3.1% 3.8%Revival of LSM growth is the key to FY10 GDP growth. Beyond FY10,we remain conservative and expect benchmark GDP growth of 5% tobe achieved by FY13.

Large Scale Manufactur ing Growth -8.2% 0.9% 3.2%

A positive growth is expected on the back of lower interest rates,declining international input prices and improvement in law & order issues. But, energy crisis and increase in electricity charges mayremain a hurdle.

Agric ultu re Growth 4.7% 3.5% 3.7%

We are anticipating a conservative Agriculture growth due to expectedslippage in some of the major crops targets. However, upside risk toour forecast is the improvement in water availability on the back of recent rains.

Services Growth 3.6% 3.7% 4.0% The intensity of both positive and negative factors seems in equilibrium,which may lead to services sector recording a mild growth during FY10.

CPI Infl ation (FY Avg .) 20.8% 9.7% 6.5%

High base effect will continue to decelerate inflation, taking it to singledigit by Nov09. However, foreign-inflow led liquidity after Oct09 mayinduce demand-pull pressures. Beyond FY10, we do not foresee FY09mayhem to repeat in the near future, despite sporadic demand/supplypressures.

6M KIBOR (FY Avg .) 14.0% 11.2% 9.8%Based on our expectation of a cumulative 250bps cut in DR by 3QFY10Monetary Policy and better liquidity from 2HFY10 onwards, we expectbenchmark KIBOR to ease going forward.

6M T-Bil l (FY Avg.) 12.8% 10.9% 9.4%Declining inflation expectation, softening Monetary Policy and better market liquidity are expected to force secondary market yieldsdownward.

Current A/C Deficit (% of GDP) 5.3% 5.2% -

Given lower oil prices (on YoY basis), import bill is expected to remainlower than FY09 level. But exports and remittances are likely to takesome hit. Therefore, FY10 CAD will only be slightly lower than FY09level.

PKR/USD (FY Avg .) 78.7 82.5 83.8

Expected foreign inflows for budgetary support will further cushionexchange rate, though speculative buying pressures may remain intact.Foreign repayment pressure may start augmenting by end-FY11, whichwill have a consequential impact on FY12 exchange rate.

Fiscal Deficit (% of GDP) 4.3% 4.9% -

Due to IMF pressure, meeting this target will be mandatory. GoP s taxrevenue target of PKR1,513bn for FY10 looks over-optimistic. Thismay force GoP to cut PSDP significantly in order to meet the fiscaldeficit target.


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FY10: Mild Shift from Stabilizationto GrowthAfter a troublesome fiscal year, economys stabilization indicators are set to recover

further during FY10. In our view, the intensity of the risks facing industrial production,

inflation, cost of financing and external account have mostly tamed. Nonetheless, these

variables are expected to face mild shocks throughout FY10, which may slowdown the

implementation of growth-oriented policies and may place checks on the extent of

economic growth. Furthermore, LSM sector is expected to get into the positive growth

zone, while Agriculture sector is expected to record a conservative growth in FY10. We eye

3.1% real GDP growth in FY10.

Our GDP growth forecasts are cautiously optimistic

FY08A FY09A FY10E FY11E FY12E

Real GDP 4.1% 2.0% 3.1% 3.8% 4.4%Agriculture 1.1% 4.7% 3.5% 3.7% 4.0%LSM 4.0% -8.2% 0.9% 3.2% 4.8%

Services 6.6% 3.6% 3.7% 4.0% 4.5%



8/33



Revival of LSM Growth will be theKeyLSM sector has kept facing the headwinds throughout the year, contracting by 8.2%YoY in

10MFY09 - the largest contraction in 35 years. More importantly, this contraction has beenbroad-based, with all of the major sub-sectors taking the hit. Although some of the sectors

including chemicals, cement and fertilizers did show resilience, their relatively small

combined weight in LSM (~10%) has kept the overall LSM growth negative.

Reduction in interest rates and lower industrial input prices are

expected to support industrial productionWith a gradual fall in inflation, we expect the Central Bank to steadily decrease the

Discount Rate in FY10 (our expectation is 250bps cumulative reduction by 3QFY10

Monetary Policy), which will have a positive effect on both demand and supply sides. The

subsequent decline in KIBOR should help in bringing down the cost of production.

Nevertheless, despite the decrease in interest rates, since no major liquidity is coming in

the monetary system before the expected disbursement of Friends of Pakistan (FoDP)

pledges after September 2009, banks may continue to be risk-averse towards private

sector lending.

Consensus Forecasts of major Industrial Input Prices

Q2-2009A Q3-2009F Q4-2009F 2010F 2011F 2012FNYMEX WTI (USD/bbl) 51.5 58.0 61.5 68.6 85.0 93.0Coal (USD/mt) 64.5 72.5 83.0 99.5 - -Aluminum (USD/mt) 1,433 1,460 1,540 1,744 2,271 2,425Copper (USD/mt) 4,203 4,354 4,325 4,800 4,800 6,393Iron Ore (USD/dmtu) 1.01 1.0 1.0 1.0 1.0 1.0

UK BP Natural Gas 40.0 47.8 54.5 52.3 52.0 56.0Source: Bloomberg consensus forecast as of July 20, 2009

On the demand side, declining interest rates are expected to gradually reinitiate consumer

financing during 2HFY10. Moreover, international industrial input prices seem to have

Performance of Key LSM sub-sectors in FY09 Break-up of LSM sector (FY09)

Source: Elixir Research Source: Elixir Research

-9%

1%

0%

-32.1%

-0.2%

17%

-26%

6%

-33%

4%

-23%

-40% -30% -20% -10% 0% 10% 20%

Petroleum

Cotton Yarn/Ginned

Paper & Board

Sugar

Beverages

Fertilizers

Steel Products

Cement

Autos

Chemicals

Electrical Appl.Petroleum, 5.2

%

Cotton, 24.0%

Fertilizers, 3.4%

Food, 14.4%

Iron &Steel, 3.5%Cement, 4.1%

Autos, 4.0%

Pharma, 5.0%

Others, 36.5%


9/33



calmed down after an abnormal surge in 2008. Global commodity price forecast reveals

that these prices are expected to increase only slowly in FY10 and beyond.

Improvement in law & order situation will bode well for production andsupplies

Swat operation is drawing closer to a positive conclusion and we expect improvement in

law & order situation at the Northern borders to resurrect domestic production once again.

According to MoF estimates, GoP lost PKR563.7bn in FY09 alone on account of loss of

exports, industrial inputs, taxes etc. due to War on Terror. Nonetheless, the possibility of

Taliban regrouping once again in the Tribal Belt cannot be ruled out; which will open up a

new war front and may force GoP to incur further direct and indirect costs.Resolution of energy crisis has become more than crucial

In FY10 Budget, GoP has intended to create a Holding Company which will (a) arrange

PKR92bn TFC for PEPCO to clear its dues to IPPs and oil & gas companies (b) pick up its

entire PKR80bn arrears against FATA, and (c) assist in settling PKR61bn PEPCO payables.

Moreover, GoP has also sketched a rather optimistic power development plan for FY10.

GoP Power Development Plan FY10

FY09 FY10T YoY

Total Installed Capacity (MW) 20,843 24,701 19%Maximum Demand (MW) 19,793 21,278 8%

Energy Generation (GWh) 93,565 107,116 14%System Losses (%) 21 20 -2%

Electrification of Villages/Abadies (Nos.) 141,360 155,399 10%

Source: Planning Commission

However, in spite of GoPs launching of PKR82bn TFC during March 2009, no realistic

improvement in power supply has been observed. Moreover, against the IMFs condition of

eliminating power subsidies, GoP has announced the schedule of increase in power tariff

up to 24% in three phases starting from October 2009. Going forward, although power

International Price Indices have nosedived after July08 KIBOR is trading well below Nov08 levels

Source: IMF Source: Elixir Research

8%

9%

10%

11%

12%

13%

14%

15%

16%17%

2 - J a n - 0

8

2 - F e b - 0

8

2 - M

a r - 0

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c t - 0

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a r - 0

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6M-KIBOR 12M-KIBOR

0

50

100

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250

300

J a n - 0

6

M a r - 0

6

M a y - 0

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M a y - 0

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S e p - 0

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N o v - 0

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J a n - 0

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M a y - 0

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J u l - 0 8

S e p - 0

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N o v - 0

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M a r - 0

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M a y - 0

9

In du str ial In pu t Pr ice In dex En er gy Pr ice In dex


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projects in the offing may start coming online from December 2009, overall improvement

in power availability may not be visible before 4QFY10.

The process of LSM revival would be slow and steady

Despite these positives, we expect LSM growth to remain slow and steady rather than

witnessing a production spike. Key risks still looming over the LSM sector include increasinginternational crude oil prices, slow disinflation and lags in implementing power projects.

We expect 0.9% growth in LSM during FY10.


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Correlation b/w Agri Credit and Agriculture growth is not very strong

Credit Supply (PKR bn) Growth in Credit Supply Growth in AgricultureValue Added (% YoY)

FY05 108.7 48.0% 6.5%FY06 137.5 26.4% 6.3%

FY07 168.8 22.8% 4.1%FY08 211.6 25.3% 1.1%

FY09 233.0 10.1% 4.7%

Source: MoF, Elixir Research

International DAP prices are expected to remain subdued

The International Fertilizer Industry Association (IFA) is expecting DAP demand to remain

lower than its supply in the medium term (2009-10), resulting in inventory pile up. This

may incentivize domestic consumers to switch from Urea to DAP in order to increase per

hectare yield.

We expect 3.5% Agriculture sector growth during FY10 GoP is expecting rice and maize to record subdued production as compared to FY09 levels

and expects sugarcane to outperform FY08 crop. We believe that rice may even fall below

the expected level on the back of (a) shortage in irrigation water availability and (b) a

steep fall in international rice prices which may act as a disincentive for local farmers. As

a result, some of the area under rice crop production may shift to sugarcane, resulting in

better sugarcane production numbers in FY10. Nonetheless, the upside risk to our forecast

is any improvement in water availability owing to the recent rains.

Major Crops: Performance and Targets

FY08A FY09A FY10T

Rice ('000 MT) 5,563 6,952 5,949Maize ('000 MT) 3,605 3,624 3,414Sugarcane ('000 MT) 63,920 50,046 56,527

Cotton (Mn bales) 11.7 12.1 13.4

Wheat ('000 MT) 20,959 23,421 -

Source: MoF

Declining prices: Disincentive for local farmers? International DAP supply to remain higher than demand

Source: Food and Agriculture Organization, Elixir Research Source: IFA, Elixir Research

0

10

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J a n - 0 7

M a r - 0

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M a r - 0

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J u l - 0 8

S e p - 0

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N o v - 0

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J a n - 0 9

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M a y - 0

9

Mai ze, USD/To n (L HS) Ri ce, USD/Ton (LHS)Wh eat, USD/To n (L HS) Co tto n, US Cen ts/l b (RHS)

75%

76%

76%

77%

77%

78%

78%

79%

79%

80%

0

5

10

15

20

25

30

35

40

45

50

2009 2010 2011 2012 2013

Phos. Acid Supp ly, MM Ton (LHS)

Fertilizer Demand , MM To n (LHS)

Demand as % of Suppl y (RHS)


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Services sector: Resilience LostAfter averaging around 7% during FY04-08, Services sector growth has also declined to

3.6%YoY in FY09. In particular, investment in the Finance & Insurance subsector has fallen

significantly; resulting in its contraction by 1.2% and reducing its contribution to overall

GDP growth from 6.4% in FY08 to 6.2% in FY09.

Moreover, banking sectors profitability has also been hurt due to the decline in overall

corporate profitability, particularly in LSM sector. Decline in overall profitability has

translated into pile up of Non-Performing Loans. Finally, responding to monetary

tightening and sensing the slowdown in economic growth, capital market fell 59% during

July 2008 - January 2009 time period. However, the local capital market has recovered

subsequently and has surged by 42% since January 2009.

Services sector resilience in jeopardy Investment in Finance & Insurance has declined

Source: MoF, Elixir Research Source: MoF, Elixir Research

NPLs have increased to alarming levels KSE-100 Index: Fall from grace in FY09

Source: SBP, Elixir Research Source: Elixir Research

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

-5%

5%

15%

25%

35%

45%

55%

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

Finance & In surance (LHS)

Services Sector (RHS)

Transpor t, Storage & Co mm. (RHS)

01020

30405060708090

2%

3%

4%

5%

6%

7%

8%

9%

F Y 0 3

F Y 0 4

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

Real In vestment in Finance & Insu rance, PKR bn (RHS)

Share in Total In vestment (LHS)

0

50

100

150

200

250

300

350

400

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

M a r - 0

5

J u l - 0 5

N o v - 0

5

M a r - 0

6

J u l - 0 6

N o v - 0

6

M a r - 0

7

J u l - 0 7

N o v - 0

7

M a r - 0

8

J u l - 0 8

N o v - 0

8

M a r - 0

9

NPLs, PKR bn (RHS)

Net NPLs to Net L oans (LHS)

0

200

400

600

800

1000

1200

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

J u l - 0 4

D e c - 0

4

M a y - 0

5

O c t - 0

5

M a r - 0

6

A u g - 0

6

J a n - 0 7

J u n - 0 7

N o v - 0

7

A p r - 0

8

S e p - 0

8

F e b - 0

9

Mkt. Vo l, Mn Sh ar es (RHS) K SE100 i nd ex (L HS)


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We expect Services sector to record a mild growth of 3.7% du ring FY10

The balance of both positive and negative factors seems in equilibrium, which may lead to

Services sector recording only a mild growth during FY10. On a positive note, revival of

manufacturing sector and reduction in interest rates are expected to indirectly benefit the

Services sector. Nonetheless, reduction in imports, slowdown in agriculture production,

and relative decline in banking profitability may keep Services sector from repeating the

FY03-07 growth performance.


15/33



FY10 Fiscal Policy: Pro-Keynesiansat WorkIn the backdrop of a troublesome FY09, present government presented its second budget

under the shadows of optimism. In our view, if governments last budget was propagating

austerity, the FY10 budget offers a visible shift toward promoting economic growth with a

Keynesian tinge to ward off the fear of a prolonged economic slowdown.

To us, the FY10 budget revolves around two Keynesian notions Countercyclical fiscal

policy and Crowding-in.

Countercyclical Fiscal Policy

In dif fi cult t imes, spend everyt hing in your pocket, and others t oo!

FY10 budget has planned 79% higher development expenditure (including 54% higher PSDP),

translating into a fiscal deficit of 4.9% of GDP compared to 4.3% in the last fiscal year.

Therefore, effectively, GoP is eyeing to increase public spending through borrowing to

create market for business production and stimulating consumer spending. The increase inconsumer spending is further expected to spur domestic production through multiplier

effect. Thus, GoP is aiming a countercyclical policy instead of saving in the hard times,

spend everything at your disposal.

Crowding in instead of Crowding out

According to the classical school of thought, deficit spending diverts all of the available

resources to the government. As a result, supply of government securities increases,

leading to high interest rates and crowding out private sector from debt markets.

Nevertheless, Keynesian school offers a different explanation to the deficit spending.

According to Keynesians, government borrowing leads to spending on large-scale projects,

which in turn creates better cash flow and spurs business optimism. In such an

environment, government spending is complemented by private investment (through

different private firms taking part in public projects) rather than substituted. Therefore,

private investment is expected to be crowded in instead of crowded out by public

spending. GoPs idea of Public Private Partnership is exactly what the principle of

crowding in dictates.

Is something wrong with this approach?

We do not think so! In fact, there are limited alternative policies available anyway. In our

view, with the lack of domestic resources, GoP has rightfully planned to pump foreign

borrowing into public spending. Having said that, it is also worth highlighting that the risks

of slippage are many and GoPs focus toward long-term fiscal revamping is still in haze.

Over-reliance on external financing straining fiscal independence

Around 43% of FY10 fiscal deficit is expected to be financed through external resources -

highest share of external financing during the last four fiscals. Although not many

alternatives were available to GoP, still this over-reliance on external funding has long

term consequences in terms of a) increasing external debt burden in the years to come and

b) straining fiscal independence of the government.


16/33



FY10 Budget SnapshotFiscal Deficit Financing of Fiscal Deficit

PKR bn

FY09 FY10Growth

PKR bn

FY09 FY10Growth

Revised Budget Revised Budget

(A) Expendi tures 1,966 2,350 20% (A) External Resources 170 312 84%

Current (excl. Foreign Repayments) 1,528 1,567 3% External Loans 348 445 28%PSDP 419 646 54% of which:

Other Development Expenditure 59 157 167% Global Bonds 0 41 -Less: Operational Shortfall in PSDP 40 20 -50% Friends of Pak.Forum 0 145 -

(B) Net Revenue Receipts 1,224 1,371 12% External Grants 20 65 233%Tax Revenue 1,180 1,513 28% of which:FoP Forum 1 46 4766%Surcharge / Levy 156 30 -81% Less: Short Term Credit 76 66 -14%

of which: PDL 129 0 -100% Less: Foreign Repayments 121 132 9%Non Tax Revenue 448 484 8% (B) Privat izatio n Proceeds 1 19 1400%Less: Revenue Transfers to Provinces 560 655 17% (C) Bank Bor row ing 146 145 -1%

(C) Provi ncial Contr ibut ion 161 246 52% (D) Non-Bank Bor rowi ng 246 246 0%Self-Financing of PSDP by Provinces 124 173 40% PIBs -10 5 -

Provincial Surplus(+) / Deficit(-) 38 73 94% Ijara Sukuk Bonds 36 0 -(D) Net Recovery of Loans 18 10 -44% T-Bills 0 1 -

from Provinces 21 20 -3% NSS 214 231 8%from Others 18 18 1% G.P. Funds/Net Deposits 2 3 116%Less: GoP Investment/Loan/Advance 21 29 36% Others 5 5 11%

Overall Fiscal Defici t (A-B-C-D) 563 723 28% Total Financi ng (A+B+C+D) 563 723 28%Fiscal Deficit as % of GDP 4.3% 4.9% -


Share in financing the Fiscal Deficit


0%

10%

20%

30%

40%

50%

60%

70%

80%

FY07 FY08 FY09 FY10

Exter nal Pr ivati zati on B an k B or ro wi ng No n-Ban k Bo rr owi ng


17/33



Revenue Targets: Same old optimism!Improvement in Tax-to-GDP ratio is still a far cry

Under the influence of IFIs, GoP embarked upon a comprehensive tax reform program

during the early 1990s, which included the enhancement of tax-to-GDP ratio, improving

direct-indirect tax mix, revamping Central Board of Revenue and removing systemloopholes. Nevertheless, barring sporadic successes, tax-to-GDP ratio has essentially been

on the decline. According to our assessment, FY10 tax policy is mere rhetoric and does not

have a clear-cut solution to increase the tax-to-GDP ratio in medium or the long term.

Optimistic tax revenue target takes another blow!In FY10 Budget, GoP set a tax collection target of PKR1.5tn (28% higher than FY09), which

after the abolition of Carbon Surcharge, has apparently come down to PKR1.37tn.

Therefore, according to GoPs own GDP growth estimate, tax to GDP ratio would fall to

9.4% of GDP as compared to around 14.0% during 1990s.

Tax Collection with and with out Carbon SurchargeFY09 FY10 Budg et

PKR bn Revised With Surcharge Without Surcharge

FBR Taxes 1,179 1,377 1,377Income Tax 443 536 536Custom Duty 145 167 167Sales Tax 457 516 516Federal Excise 116 137 137Others 17.7 21.1 21.1

Taxes (Other than FBR) 1 136 2

Total Tax Collec tion 1,180 1,513 1,379


Tax-to-GDP ratio vs. Real GDP growth


9%

10%

11%

12%

13%

14%

15%

0%1%2%3%4%5%6%7%8%9%

10%

F Y 9 1

F Y 9 5

F Y 9 6

F Y 9 7

F Y 9 8

F Y 9 9

F Y 0 0

F Y 0 1

F Y 0 2

F Y 0 3

F Y 0 4

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

Real GDP Gr owth (L HS) Tax-to -GDP (RHS)


18/33



The Carbon Surcharge Saga

GoP introduced a new taxation measure in the form of Carbon Surcharge in FY10 budget,

which was expected to yield PKR134bn. In our view, this new measure was ironic from

many aspects:

It was included in the tax revenue but labeled Surcharge, which in our view was anattempt to brush off provincial claims on the proceeds of this revenue. Surprisingly, no

voice was raised from provinces. Theoretically, Carbon tax is an example of corrective tax - also called Pigovian Tax

after classical economist Arthur Pigou - which is imposed in order to reduce negative

externalities from a market outcome (in this case, to discourage carbon emission).

Nevertheless, GoP used it solely to increase revenue since, ironically, it was also

imposed on CNG.

Subsequently, PPP government was forced to revoke Carbon Surcharge on CNG

immediately after the budget, while surcharge on POL products was suspended by the

Supreme Court on 7 th July, 2009. GoP representatives accepted that imposition of the

Carbon Surcharge was a mistake and on the very next day, GoP reverted back to the oldPDL (now called Petroleum Levy) through a Presidential Ordinance in order to fill the

revenue shortfall created on the back of Carbon Surcharge suspension. However, according

to our oil analysts estimates, the GoP would be able to fetch PKR110-115bn - at most -

from the Petroleum Levy during FY10, compared to GoPs target of PKR122bn.


19/33



Federal Subsidies: Capping unproductive spendingGoP allocated PKR132bn for federal subsidies in FY10; almost half of what was provided in

FY09. In our view, this run down on subsidies is entirely induced by IMFs prescription. We

believe that slashing unproductive subsidies is the right step since they do not directly

contribute in creating output and their multiplier effect is far less than that of

development spending.

We expect GoP to do away with the unproductive subsidies during FY10. However, in FY10,

removal of power subsidies is expected to be gradual since GoP has planned to increase

power tariff in three phases i.e. October 2009, January 2010 and April 2010.

Breakup of Federal SubsidiesFY09 FY10

GrowthPKR bn Revised Budget

Power Subsi dies 112 67 -40%

WAPDA 93 63 -32%

Interest on WAPDA TFC 0 30 -

KESC 19 4 -80%KESC Payable to PSO and PGCL 0.3 0.3 0%

Food Subsidies 30 34 12%

Import of Wheat 20 26 28%

Import of Sugar 6 4 -37%

Relief through Utility Stores 4 4 11%

Oil Refineries/OMCs/Others 70 15 -79%

Fertil izer Subsidies 32 10 -68%

Others 9 7 -24%

Total Subsidies 252 132 -48%

Source: Federal Budget in Brief FY10

Fiscal Deficit target is achievable, but PDSP is indangerFY10s fiscal deficit (4.9% of GDP) is the key target which GoP cannot afford to miss,

primarily due to fiscal deficit being IMFs one of key focuses. Therefore, in spite of GoPs

stance of spurring growth through expansionary fiscal policy, we believe that PSDP target

of PKR646bn is quite vulnerable to fiscal deficit adjustments. Despite being optimistic

regarding external funding arrangement, we believe that revenue targets are stretched,

which will have a consequential impact on FY10 development spending.

With our forecast of 3.1% real GDP growth and 9.7% inflation in FY10, we believe that

maintaining fiscal deficit at 4.9% of GDP would require slashing public spending by

approximately PKR120-125bn. Therefore, being the weakest victim of fiscal consolidation,

PSDP may once again take the brunt.


20/33



Oil Prices, Exports, Remittances:Make or Break for External AccountWith foreign investment inflow expected to remain sluggish, we believe that trade account

and remittances will be the key areas to look out in FY10. In our view, recent global

developments may act as counterbalancing forces for Pakistan - posing threats on one hand

and offering opportunities on the other.

Current Account Deficit to remain 5.2% of GDPPakistans current account deficit has come down to 5.3% of GDP in FY09 compared to 8.5%

in FY08, thanks largely to relatively lower oil and other commodity prices, translating into

10.4%YoY lower imports during FY09. In addition, exports and remittances remained

healthy throughout FY09 despite initial fears. However, in FY10, although imports may

remain subdued, exports and remittances are expected to face the lagged consequences of

global economic crunch and are anticipated to decline by 20.6%YoY and 9.9%YoY

respectively. With these assumptions, we anticipate current account deficit to remain 5.2%

of GDP in FY10.

On a positive note, overall balance of payment situation would be much better in FY10

largely because of expected foreign budgetary support.

Balance of Payment Outlook fo r FY10

USD mn FY08A FY09A FY10ECurrent A/C Balance -13,866 -8,861 -9,239

CAB as % of GDP -8.5 -5.3% -5.2

Trade Balance -14,970 -12,494 -11,540

Exports 20,427 19,222 17,319

Imports 35,397 31,716 28,860

Services and Income Balance -10,372 -7,569 -7,599Balance of Current Transfers 11,476 11,202 9,900

of which: Remittances 6,451 7,811 6,200

Capital and Financial A/C 8,256 5,170 8,490

Net Errors and Omissions 103 391 0

Overall Balance of Payment -5,507 -3,300 -749

Forecast accounts for all external funding except IMF's Loan.

Source: SBP, Elixir Research


21/33



Exports are expected to take the lagged hitThe global economic turmoil has been mildly consequential for Pakistans exports, as they

have declined 5.9%YoY in FY09. Around half of the exports comprise of textile exports,

which recorded 5.6%YoY decline during FY09. However, this decline has been slightly

moderated by food group and cement exports, which posted 8%YoY and 71.1%YoY increase

respectively.

Pakistans Major Exports

PKR bn FY08 FY09 %YoY

Total Exports 20,427 19,222 -5.9%

of which

Food 2,588 2,795 8.0%

Textiles 10,354 9,775 -5.6%

Sports 415 385 -7.4%

Leather Products 831 749 -9.8%

Chemical & Pharma 664 668 0.5%

Engineering 325 347 6.8%

Cements 354 606 71.1%

Others 4,895 3,897 -20.4%


Going forward, we expect limited support from cement sector in FY10 as international

capacities, especially in Middle East, are likely to come online. Furthermore, according to

news reports, export orders had started getting canceled during late FY09, which may

translate into even lower textile exports during FY10. Therefore, owing to the lagged

effect of global economic turmoil, we expect export proceeds to remain around 10%YoY

lower in FY10.

Long term trend in Exports


0.8

1.0

1.2

1.4

1.6

1.8

2.0

J u l - 0 3

N o v - 0

3

M a r - 0

4

J u l - 0 4

N o v - 0

4

M a r - 0

5

J u l - 0 5

N o v - 0

5

M a r - 0

6

J u l - 0 6

N o v - 0

6

M a r - 0

7

J u l - 0 7

N o v - 0

7

M a r - 0

8

J u l - 0 8

N o v - 0

8

M a r - 0

9

USD bn


22/33



However, global economic recovery can triggerexports beyond FY10Prospects for Pakistans exports hinge on how quick the global economic recovery takes

place; especially in those economies which are Pakistans export destinations. After

witnessing 3.3% contraction in real GDP during 2009, major markets that are destination

for Pakistans 50% exports are expected to record 0.2%, 2.2% and 2.7% GDP growth in 2010,

2011 and 2012 respectively.

Economic outloo k of Pakistan's export markets

Share in Pak.Exports

Real GDP Growth Demand-Output Gap (as% of GDP)

2009 2010 2011 2012 2009 2010

USA 19% -2.8% 0.0% 3.5% 3.6% 4.1% 5.5%

UAE 8% -0.6% 1.6% 3.3% 4.6% - -

United Kingdom 5% -4.1% -0.4% 2.1% 2.9% 5.5% 6.6%

Germany 4% -5.6% -1.0% 1.5% 1.8% 5.8% 7.2%

Italy 3% -4.5% -0.4% 0.7% 1.4% 5.1% 5.7%Netherlands 3% -4.8% -0.7% 1.7% 2.1% 4.3% 5.9%

Saudi Arabia 2% -0.9% 2.9% 4.4% 4.9% - -

Spain 2% -3.0% -0.7% 0.9% 1.3% 0.9% 2.0%

Belgium 2% -3.8% 0.3% 1.8% 2.0% 3.8% 4.7%

France 2% -3.0% 0.4% 1.7% 2.0% 4.5% 5.2%

Average -3.3% 0.2% 2.2% 2.7% 4.2% 5

Source: IMF, Elixir Research

Increasing global demand-output gap provides room for exports

Demand-output gap is essentially the difference between domestic aggregate demand and

domestic aggregate supply. In case of a positive gap, excess demand is satisfied throughimports. In Pakistans export markets, (average) demand-output gap is expected to widen

from 4.2% of GDP in 2009 to 5.3% in 2010. In this scenario, we believe that Pakistan can

capitalize on its strength, i.e. low value added exports due to their relatively inelastic

demand.

Supply side improvements will also play their role, but rapidimprovement in export performance is still a far cry

In spite of the expected improvement in global import demand, domestic production

performance largely depends on cost of financing, law & order issues and energy crisis

the three most important supply side factors. We believe that the reduction in Discount

Rate, GoPs progress in War on Terror and efforts to resolve energy crisis will help inboosting domestic production going forward. However, we also believe that the road to

recovery is not going to be smooth. The expected improvement in both endogenous and

exogenous factors will not be immediate and may take some time to translate into higher

exports.


23/33



International oil prices are declining, but the upsiderisk is not out of the questionAfter peaking in May 2008 (~USD128/bbl), Arab Light prices nosedived in December 2008 to

~USD33/bbl amidst deteriorating aggregate demand worldwide. Since January 2009, mixed

signals of revival in global economies have been jacking up oil prices once again. However,

current levels show that oil prices have been approaching their long term trend with a

significant reduction in mean absolute deviation from long term average.

Moreover, given the expectations of a mildly positive world economic growth in 2010, oil

prices are expected to remain range-bound. Nevertheless, a firm and quicker than

expected global economic recovery can put an upward pressure on oil prices.

How sensitive is our current account to changes in oil prices Oil imports constitute 29% and 20% of Pakistans total import bill and current account

outflows respectively. The sensitivity analysis of changes in oil prices and Pakistans

current account balance is given below. Nonetheless, due to their integrated and broad-

based impact on various economic indicators including fiscal deficit and inflation, the

effective impact of increase in international oil prices would be more severe than just

affecting the current account balance.

Sensitivity of FY10 Current Account Balance to Oil Prices

FY10 Arab Light (USD/bbl) Assumpti onsUSD bn 55 62.5 75 80 90

Current Account Balance -8.8 -9.2 -10.0 -10.3 -11.0of whichTrade Balance -11.1 -11.5 -12.3 -12.6 -13.3Exports 17.3 17.3 17.3 17.3 17.3Imports 28.4 28.9 29.6 30.0 30.6Oil Imports 8.6 9.0 9.8 10.1 10.8

Current Account Balance (as % of GDP) -4.9% -5.2% -5.6% -5.8% -6.1%

Trade Balance (as % of GDP) -6.2% -6.4% -6.9% -7.1% -7.4%


Oil Prices reverting to their mean Intl Oil Prices expected to remain around current levels

Source: Bloomberg, Elixir Research Source: EIA

020406080100120140160

0102030

405060708090

0 1 - J u l - 0

4

0 1 - N o v - 0

4

0 1 - M a r - 0

5

0 1 - J u l - 0

5

0 1 - N o v - 0

5

0 1 - M a r - 0

6

0 1 - J u l - 0

6

0 1 - N o v - 0

6

0 1 - M a r - 0

7

0 1 - J u l - 0

7

0 1 - N o v - 0

7

0 1 - M a r - 0

8

0 1 - J u l - 0

8

0 1 - N o v - 0

8

0 1 - M a r - 0

9

0 1 - J u l - 0

9

M ean Abso lu te Dev iat ion (LHS) Arab Ligh t, USD/bb l (R HS)

0

20

40

60

80

100

120

140

160

J a n - 0 5

M a y - 0

5

S e p - 0

5

J a n - 0 6

M a y - 0

6

S e p - 0

6

J a n - 0 7

M a y - 0

7

S e p - 0

7

J a n - 0 8

M a y - 0

8

S e p - 0

8

J a n - 0 9

M a y - 0

9

S e p - 0

9

J a n - 1 0

M a y - 1

0

S e p - 1

0

WTI (USD/bbl) EIA Forecast


24/33



Relative improvement is mitigating investment riskSevere balance of payment crisis and endogenous weaknesses led to the downward revision

of Pakistans sovereign rating in November 2008. This was a severe blow to the investment

attractiveness of Pakistan, which reflected in Credit Default Swap (CDS) spread of GoP

sovereign bond reaching new peaks above 5,000bps. After IMFs balance of payment

support, fall in international oil prices and subsequent stabilization of exchange rate, CDS

declined to around 1,700bps by the end of May 2009. However, CDS of Pakistans sovereign

bonds is still higher than the levels sustained during FY06-07.

GoP Sovereign RatingsLocal Currency Foreign Currency

Long Term Outlook Short Term Long Term Outlook Short Term

Dec. 19, 2008 CCC+ Developing C CCC+ Developing C

Nov. 14, 2008 CCC+ Developing C CCC Developing C

Oct. 06, 2008 B- Negative C CCC+ Negative C

May 15, 2008 BB- Negative B B Negative B

Nov. 6, 2007 BB Negative B B+ Negative BJul. 12, 2007 BB Stable B B+ Stable B

Dec. 19, 2006 BB Positive B B+ Positive B

Dec. 28, 2005 BB Stable B B+ Positive B

Nov. 22, 2004 BB Stable B B+ Stable B

Dec. 2, 2003 BB- Positive B B Positive B

Dec. 12, 2002 BB- Stable B B Stable B

Dec. 21, 1999 B+ Stable B B- Stable B

Source: Standard & Poor's

CDS spread of GoP sovereign bonds: Rise and Fall

Source: Bloomberg

-

1,000

2,000

3,000

4,000

5,000

6,000

2 - J u l - 0

7

2 - S e p - 0 7

2 - N o v - 0 7

2 - J a n - 0 8

2 - M a r - 0 8

2 - M a y - 0

8

2 - J u l - 0

8

2 - S e p - 0 8

2 - N o v - 0 8

2 - J a n - 0 9

2 - M a r - 0 9

2 - M a y - 0

9

5-Year 10-Year bp s


25/33



Remittances: So far so good; but will they remainso?Since labor markets are highly sensitive to recessionary cycles, decline in remittances was

anticipated to precede the decline in exports. Nevertheless, remittances have increased

by 21.1%YoY in FY09 to USD7.8bn, surpassing GoPs full year (FY09) target of USD7.7bn.

However, there is a possibility that the remittances during late FY09 were one-off inflows

due to expatriates returning home with their offshore savings. Moreover, increasing

reliance on USA, UK and GCC countries have made remittances vulnerable to negative

economic shocks in these economies.

We believe that, at a time when there are mixed signals regarding the timing of the start

of global economic growth, remittances will take a hit during FY10. We expect USD6.2bn

remittances in FY10 as against GoPs target of USD6.7bn.

Inflow of Workers Remittances Overre liance of Remittances from USA, UK and GCC


200

300

400

500

600

700

800

J u l - 0 5

O c t - 0

5

J a n - 0 6

A p r - 0

6

J u l - 0 6

O c t - 0

6

J a n - 0 7

A p r - 0

7

J u l - 0 7

O c t - 0

7

J a n - 0 8

A p r - 0

8

J u l - 0 8

O c t - 0

8

J a n - 0 9

A p r - 0

9

USD mn

0%10%20%30%40%50%60%70%80%90%

100%

J u l - 9 6

A p r - 9

7

J a n - 9 8

O c t - 9

8

J u l - 9 9

A p r - 0

0

J a n - 0 1

O c t - 0

1

J u l - 0 2

A p r - 0

3

J a n - 0 4

O c t - 0

4

J u l - 0 5

A p r - 0

6

J a n - 0 7

O c t - 0

7

J u l - 0 8

A p r - 0

9

f ro m USA ,UK & GC C f ro m Oth er s


26/33



Exchange Rate: Headwinds gone,but Depreciation is still thereExchange rate witnessed an abrupt depreciation between 16 th April and 17 th October, 2008

(PKR/USD: down 32%) after remaining stable at around PKR61.0 for more than two years.

Soaring import bill on the back of high international oil prices coupled with flight of

foreign capital owing to economic and political chaos were the two main factors behind

steep depreciation of PKR/USD parity.

Fall in oil prices and IMFs SBA have stabilized the exchange rate, butPKR has lost 19.1% value while finding the new equilibrium

Exchange rate gradually started stabilizing around PKR80/USD level after the fall in

international oil prices in September 2008. In addition, Standby loan agreement with IMF in

November 2008 provided much needed cushion to the external account. These two positive

developments halted the exchange rate depreciation to a great extent. This is reflected by

the fact that PKR shed only 2.9% of its value during 2HFY09 compared to 14.7% during

1HFY09. Moreover, although modest pressures are apparent, volatility of exchange rate has

reduced considerably. The fact, nevertheless, remains that the local currency has lost

19.1% of its value between FY08 and FY09 in order to find a new equilibrium.

Shift of FO payments to interbank market in August 2009: Exchangerate to face headwinds

With the start of FY10, exchange rate appears to be facing pressures as it has depreciated

from PKR80.8 on 3rd June 2009 to above PKR83.0 recently. In our view, this pressure hasbeen caused by the SBPs forthcoming transfer of diesel and refined oil products to the

interbank market from August 2009 onwards and delay in IMF tranche. In our view, with

the oil import bill falling from USD1,400mn in September 2008 to USD800mn in June 2009,

current PKR/USD depreciation has been caused more by speculative buying than change in

balance of payment fundamentals. However, given the fact that FY10 balance of payment

will be driven more by foreign inflows than trade account, speculative pressure may

remain pronounced in FY10, especially during 1HFY10.

Exchange rate: Dependence on oil prices is apparent Inter-day exchange rate volatility (standard deviation)

Source: SBP, Elixir Research Source: Elixir Research

0204060

80100120140160

60

65

70

75

80

85

90

3 - J u l - 0 7

3 - S e - 0

7

3 - N o v - 0

7

3 - J a n - 0 8

3 - M a r - 0

8

3 - M a y - 0

8

3 - J u l - 0 8

3 - S e - 0

8

3 - N o v - 0

8

3 - J a n - 0 9

3 - M a r - 0

9

3 - M a y - 0

9

3 - J u l - 0 9

PKR/USD (LHS) Arab Light, USD/bbl (RHS)

0.00.20.40.60.8

1.01.21.41.61.82.0

2 3 - J u l - 0

7

2 3 - S e p - 0

7

2 3 - N o v - 0

7

2 3 - J a n - 0

8

2 3 - M a r - 0

8

2 3 - M a y - 0

8

2 3 - J u l - 0

8

2 3 - S e p - 0

8

2 3 - N o v - 0

8

2 3 - J a n - 0

9

2 3 - M a r - 0

9

2 3 - M a y - 0

9


27/33



Exchange rate is expected to remain (average) PKR82.5 in FY10

In our view, most of the pressures on exchange rate are gone and, as the import cover of

FX reserves has been improving, the exchange rate is on its way towards stability. As

stated in the preceding section, we do not expect oil prices to follow any abnormal hike

during FY10, similar to one observed during FY08. Furthermore, around USD2.4bn Friends

of Pakistan pledges during FY10 (in addition to ~USD3.5bn other loans & grants), are

expected to keep the exchange rate from depreciating outrageously. Despite these

positives, we expect the exchange rate to depreciate from (average) PKR78.6/USD in FY09

to PKR82.5/USD in FY10 based on following assertions:

Although no repayment schedule regarding FY10 external funding has been announcedas yet, we believe repayments will start from FY11. Treasury market players may

position themselves against this forthcoming repayment pressure. There are strong indications of GoP going for IMFs bridge financing of USD4.0bn in

case FoDP funding gets delayed. According to news reports, the repayment of this

bridge financing will start in 4QFY10. Therefore, in our view, the positive impact of

such disbursement on PKR/USD will be minimal and it may remain under pressure. Empirically, market players focus more on the position of current account than overall

balance of payment. Since we expect only a mild improvement in current account

balance during FY10, speculative pressure may remain active in the market.

Exchange rate: Past, Present, Future Import cover of SBP FX reserves (weeks of imports)

Source: Elixir Research Source: SBP, Elixir Research

50

55

60

65

70

75

80

85

90

F Y 0 0

F Y 0 1

F Y 0 2

F Y 0 3

F Y 0 4

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0 F

F Y 1 1 F

F Y 1 2 F

F Y 1 3 F

F Y 1 4 F

0

4

8

12

16

20

24

O c t - 0

7

D e c - 0

7

F e b - 0

8

A p r - 0

8

J u n - 0 8

A u g - 0

8

O c t - 0

8

D e c - 0

8

F e b - 0

9

A p r - 0

9

J u n - 0 9


28/33



Inflation: Gradual Decline Expectedto ContinueHeadline inflation has come down to 13.1% in June 2009 after starting from 24.3%YoY in

July 2008 and touching its peak of 25.3% in August 2008; taking the FY09 average to

21.0%YoY. Moreover, after months of sticking around 19%YoY, core inflation has also

slipped to 15.9%YoY in June 2009. We believe that inflation has reached the stabilization

phase partly due to the global cool off in prices and partly due to the high base effect.

Trend in Global Inflation

After hitting their peak during late FY08, international commodity prices have collapsed in

FY09 owing to the global demand contraction. Even the prices of staple commodities,

having relatively inelastic demand, took a considerable hit eFY09.

Why has domestic inflation not followed the global inflation trend?

Despite the fall in international commodity prices and a significant domestic economic

slowdown, inflation did not nosedive in Pakistan. In our view, there are a number of

answers to this ambiguity:

Although Pakistan did experience an economic slowdown, positive GDP growth ensuredadequate level of demand-pull inflation. In developed economies, the demand-pull

forces were put to rest by negative GDP growth. Inflation expectations had remained high owing to a general negative perception

about economic recovery, which had put upward pressure on actual inflation numbers. System leakages, most importantly hoarding, has kept the prices from falling sharply. Poorly regulated markets and absence of developed commodity exchanges have kept

exogenous price signals to transfer immediately to local markets.

Trend in Staple Commodity Prices Global Inflation Trend and Outlook

Source: FAO, Elixir Research Source: IMF, Elixir Research

-3.0% 0.0% 3.0% 6.0% 9.0% 12.0% 15.0% 18.0% 21.0%

Advanced

Euro area

Developing

ASEAN-5

Middle East

Pakistan

India

China

FY00-08 FY09 FY10-14

0102030405060708090

0100200300400500600700800900

1000

J a n - 0 6

A p r - 0 6

J u l - 0 6

O c t - 0 6

J a n - 0 7

A p r - 0 7

J u l - 0 7

O c t - 0 7

J a n - 0 8

A p r - 0 8

J u l - 0 8

O c t - 0 8

J a n - 0 9

A p r - 0 9

J u l - 0 9

Maize, USD/Ton (LHS) Rice, USD/Ton (LHS)

Wheat, USD/Ton (LHS) Co tton, US Cen ts/lb (RHS)

CommodityPrices hitting thePeak


29/33



High base effect! Single digit inflation is possible in November 2 009

Month-on-Month change in inflation indicators (CPI and SPI) reveals a volatile trend with a

gradual fall in the rate of change of price indices; moderately depicting a decline in YoY-

based inflation. A steep decline in YoY-based inflation is primarily owing to the high base

effect. From 24.3%YoY in July 2008, headline inflation remained stubbornly high during

August-November 2008; averaging 25% as compared to the remaining 7MFY09 average of

18%. Observing this trend, we expect headline inflation to fall below 10% in November

2009.

Combined impact of upside risks would be relatively less severe,translating into 9.7%YoY inflation in FY10

At present, high base effect is expected to remain dominant, keeping headline inflation on

a downward trajectory until November 2009 and absorbing sporadic hikes in actual

consumer prices. Therefore, although the presence of disruptions in farm-to-market

supplies and slippages in staple commodity production targets cannot be ruled out, there

are no visible short term risks of an abrupt hike in domestic prices. However, after the

high base effect runs out of breath, there are two most apparent risks facing inflation:

Hike in electricity charges in three phases: 8-10% in October 2009, 5-6% in January2010 and 5-6% in April 2010. This may ignite inflation expectations even in the

preceding months. External financing for budgetary support is expected to flow in from October 2009

onwards, which will pump direct PKR liquidity into the market. Any abnormal growth

in liquidity (or monetary base) may once again stimulate demand-pull pressures.

Nevertheless, we believe that the combined impact of all these risks will be less severe in

FY10. We expect 9.7%YoY average inflation during FY10.

Trend in Domestic Inflation Indicators


0%

5%

10%

15%

20%

25%

30%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

J u l - 0 2

D e c - 0

2

M a y - 0

3

O c t - 0

3

M a r - 0

4

A u - 0

4

J a n - 0 5

J u n - 0 5

N o v - 0

5

A p r - 0

6

S e - 0

6

F e b - 0

7

J u l - 0 7

D e c - 0

7

M a y - 0

8

O c t - 0

8

M a r - 0

9

CPI, MoM (LHS) SPI, MoM (LHS) CPI, YoY (RHS)


30/33



A Softened Monetary Stance AheadThroughout FY09, a tight monetary policy has kept the growth in monetary base strictly in

check. In our view, although a contractionary monetary policy was necessary to curb the

increasing core inflation, GoPs weak response to address administrative issues and a

weaker price regulation mechanism reduced the monetary policy effectiveness. Instead,high interest rates and a host of shocks mopped up liquidity from the system and the

burden was borne by real sector, which witnessed a considerable slowdown during FY09.

Contractionary money supply, liquidity constraints andSBPs responseLiquidity shortage became more pronounced during 2QFY09, which is also apparent from

an alarmingly high level of O/N rates. Although O/N rates fell considerably in 3QFY09 after

GoP-IMF standby agreement, decline in private sector credit demand and reduction in debt

monetization outweighed the gradual improvement in NFA. This has dragged the M2 growth

down to alarmingly low levels. By the end of March 2009, Money supply growth had fallen

sharply to 8.6%YoY from 15.4%YoY at the start of FY09. However, 100bps reduction inDiscount Rate in April 2009 and continuous OMO injections have swiftly increased the M2

growth to 11.6%YoY in May 2009.

Liquidity position may remain under stress during 1HFY10We anticipate money market liquidity to remain in check during the 1QFY10, which may

keep the secondary market interest rates range bound. Our hypothesis is based on the

following assertions:

Against the announcement of PKR345bn 1QFY10 T-bill auction target, maturities of around PKR174bn are expected. Moreover, no maturities are coming against PIB

auction target of PKR30bn in 1HFY10. This means that a net outflow of around

PKR201.3bn from money market may keep the secondary market yields downwardsticky and range bound.

Around 43% of the FY10 budget deficit is planned to be financed through externalsources. Major external inflows are expected only after September 2009 when US

fiscal year starts, which may put a downward pressure on domestic liquidity. Although

the exact quantum of inflow in 2QFY10 is uncertain, this will include pledges under

Kerry-Lugar Bill, US Congress Bill and Friends of Pakistan Forum. Exchange rate may remain under pressure during FY10, (as discussed earlier) which

may keep NFA and thus M2 growth constrained. IMFs expected tranche (against March 2009 performance) of ~USD870mn will only be

used against short-term balance of payment obligations and not for budgetary

financing. Thus, it will not pump any direct PKR liquidity in the market.


31/33



YoY Growth in Money Supply (M2) Trend in Overnight Rates

SBPs Liquidity Management through OMOs Key Interest Rates vs. Discount Rate

NDA is under considerable pressure Freefall has stopped, but NFA is still in negative zone


8%

9%

10%

11%

12%

13%

14%

15%

16%

1 - J u l

6 - S e p

2 0 - S e p

1 1 - O c t

2 5 - O c t

8 - N o v

2 2 - N o v

1 3 - D e c

2 7 - D e c

1 0 - J a n

2 4 - J a n

1 4 - F e b

2 8 - F e b

1 4 - M a r

2 8 - M a r

1 1 - A p r

2 5 - A p r

9 - M a y

2 3 - M a y

6 - J u n

2 0 - J u n

0%

5%

10%

15%

20%

25%

1 2 - J u l - 0

8

1 2 - A u g - 0

8

1 2 - S e p - 0

8

1 2 - O c t - 0

8

1 2 - N o v - 0

8

1 2 - D e c - 0

8

1 2 - J a n - 0

9

1 2 - F e b - 0

9

1 2 - M a r - 0

9

1 2 - A p r - 0

9

1 2 - M a y - 0

9

1 2 - J u n - 0

9

O/N Repo O/N Call

0

50

100

150

200

250

300

350400

J u l - 0 8

A u g - 0

8

S e p - 0

8

O c t - 0

8

N o v - 0

8

D e c - 0

8

J a n - 0 9

F e b - 0

9

M a r - 0

9

A p r - 0

9

M

a y - 0

9

J u n - 0 9

L i qu i di ty Mo p pi ng U p L i qu i di ty In j ec ti o n

10%

11%

12%

13%

14%

15%

16%

17%

18%

2 - J u l - 0

8

2 - A u g - 0

8

2 - S e p - 0

8

2 - O c t - 0

8

2 - N o v - 0

8

2 - D e c - 0

8

2 - J a n - 0

9

2 - F e b - 0

9

2 - M a r - 0

9

2 - A p r - 0

9

2 - M a y - 0

9

2 - J u n - 0

9

2 - J u l - 0

9

6M T-Bil l 6M KIBOR 10Y-PIB DR

-100-50

050

100150200250300350400450

2 6 - J u l

1 3 - S e p

2 7 - S e p

1 8 - O c t

1 - N o v

1 5 - N o v

2 9 - N o v

2 0 - D e c

3 - J a n

1 7 - J a n

7 - F e b

2 1 - F e b

7 - M a r

2 1 - M a r

4 - A p r

1 8 - A p r

2 - M a y

1 6 - M a y

3 0 - M a y

1 3 - J u n

GoP borrowing from SBP Pvt. Sec tor Credi tPKR bn

-400

-350

-300

-250

-200

-150

-100

-50

0

2 6 - J u l

1 3 - S e

2 7 - S e

1 8 - O c t

1 - N o v

1 5 - N o v

2 9 - N o v

2 0 - D e c

3 - J a n

1 7 - J a n

7 - F e b

2 1 - F e b

7 - M a r

2 1 - M a r

4 - A p r

1 8 - A p r

2 - M a y

1 6 - M a y

3 0 - M a y

1 3 - J u n

PKR bn


32/33



We eye 250 bps cumulative reduction in Discount Rate byJanuary 2010 Monetary PolicyHeadline inflation has come down to 13.1%YoY in June 2009 from its peak of 25.3%YoY in

August 2008. Core inflation has also slid to 15.9%YoY in June 2009 after sticking around

19%YoY between October 2008 and March 2009. In addition, both current account and

fiscal deficits have come down from FY08 levels. All these indicators reveal that a

considerable level of stabilization has been achieved and need to shift focus towards

growth is imminent. We expect that the SBP may further reduce the discount rate by a

cumulative 250bps in the upcoming three monetary policies.

Secondary market interest rates to remain range bounduntil 2QFY10Going forward, we believe that reduction in the Discount Rate will only put a modest

downward pressure on interest rates. In our view, the future course of interest rates

largely hinges upon liquidity inflows in the market; especially external liquidity after

September/October 2009. Therefore, secondary market rates are expected to remain

range bound until 2QFY10. Once actual liquidity position starts improving from October

2009 onwards, we expect gradual decline in secondary market interest rates.

Expected Trend in Interest Rates


8.0%

9.0%

10.0%

11.0%

12.0%

13.0%

14.0%

15.0%

1 H F Y 0 7

2 H F Y 0 7

1 H F Y 0 8

2 H F Y 0 8

1 H F Y 0 9

2 H F Y 0 9

1 H F Y 1 0

2 H F Y 1 0

1 H F Y 1 1

2 H F Y 1 1

1 H F Y 1 2

2 H F Y 1 2

6M T-Bil l 6M-KIBOR

Elixir Fo recast


33/33

CEOFax (92-21) 24 1 8271

Karachi Sales TeamFax (92-21) 241 8925

Pakistan Debt Brokerage TeamFax (92-21) 242 3539

Mohammad Sohail

(92-21) 24 2 1812msohail @elixirsec.com

Tariq M. Choudhry(92-21) 240 [email protected]

Syed Murshid Ali (92-21) 240 [email protected]

Pakistan Research TeamFax (92-21) 242 0527

Tanvir Abid, CFA(92-21) 242 [email protected]

Intikhab Naviwala (92-21) 240 [email protected]

Faisal Khan(92-21) 241 [email protected]

Nasir Muqeet(92-21) 247 [email protected]

Amir Iqbal (92-21) 240 [email protected]

Umair Siddique(92-21) 242 [email protected]

Faisal Bilwani(92-21) 242 [email protected]

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(92-21) 247 [email protected]

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(92-21) 241 8900 [email protected]

Rizwan Mirza


Haider Hussain(92-21) 242 [email protected]

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Pakistan Forex BrokerageFax (92-21) 242 3539

Ali Kamal(92-21) 247 [email protected]

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Mohammad Asif(92-21) 244 [email protected]

Syed Tahseen Jawed


Tahir Maqbool


Zeeshan Atique


Muhammad Ibad(92-21) 240 [email protected]

Shahzad Ahmed(92-42) 571 [email protected]

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Atiq ur Rehman


The report has been prepared by Elixir Securities Pakistan (Pvt.) Ltd. (Elixir Pakistan) The information and opinions contained herein has beencompiled or arrived at based upon information obtained from sources believed to be reliable and in good faith. Such information has not beenindependently verified and no guaranty, representation or warranty, express or implied is made as to its accuracy, completeness or correctness.All such information and opinions are subject to change without notice. This document is for information purposes only, descriptions of anycompany or companies or their securities mentioned herein are not intended to be complete and this document is not, and should not be

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pakistan economy 30-july-2009

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